The purpose of this discussion and analysis is to provide information about the financial condition and results of operations of National Bankshares, Inc. and its wholly-owned subsidiaries (the Company), which are not otherwise apparent from the consolidated financial statements and other information included in this report. Refer to the financial statements and other information included in this report as well as the 2008 Annual Report on Form 10-K for an understanding of the following discussion and analysis.

Cautionary Statement Regarding Forward-Looking Statements

We make forward-looking statements in this Form 10-Q that are subject to significant risks and uncertainties. These forward-looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals, and are based upon our management's views and assumptions as of the date of this report. The words "believes," "expects," "may," "will," "should," "projects," "contemplates," "anticipates," "forecasts," "intends," or other similar words or terms are intended to identify forward-looking statements.

These forward-looking statements are based upon or are affected by factors that could cause our actual results to differ materially from historical results or from any results expressed or implied by such forward-looking statements. These factors include, but are not limited to, changes in:

• interest rates,

• general economic conditions,

• the legislative/regulatory climate,

• monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury, the Office of the Comptroller of the Currency and the Federal Reserve Board, and the impact of any policies or programs implemented pursuant to the Emergency Economic Stabilization Act of 2008 (EESA),

• the quality or composition of the loan and/or investment portfolios,

• demand for loan products,

• deposit flows,

• competition,

• demand for financial services in the Company's trade area,

• the real estate market in the Company's trade area,

• the Company's technology initiatives, and

• applicable accounting principles, policies and guidelines.

These risks and uncertainties should be considered in evaluating the forward-looking statements contained in this report. We caution readers not to place undue reliance on those statements, which speak only as of the date of this report.

This discussion and analysis should be read in conjunction with the description of our "Risk Factors" in Item 1A of our 2008 Annual Report on Form 10-K and in this Form 10-Q.

There have been historic disruptions in the financial system in the United States during the past year. While the Company has not been significantly negatively impacted during the recent economic crisis, continuation of turbulence in large portions of the global financial markets, particularly if it worsens or is prolonged, could impact the Company's performance. The impact could be direct, by affecting revenues and the value of the Company's assets and liabilities, or it could be indirect, by affecting the economy generally. Although the Company's markets have not been dramatically affected, large declines in housing values in other geographic areas of the country have resulted in significant write-downs of asset values by some financial institutions in the United States. Concerns about the stability of the U.S. financial markets generally have reduced the availability of funding to some financial institutions, leading to a tightening of credit, reduction of business activity and increased market volatility. It is not yet clear what the ultimate impact of liquidity and funding initiatives of the Treasury and other bank regulatory agencies that have been announced or other programs that may be initiated in the future will be on financial markets and the financial services industry. An extended U. S. or global recession could have an adverse effect on all financial institutions, including the Company.

Critical Accounting Policies

General

The discussion and analysis of the Company's financial condition and results of operations is based in large part upon its consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). These accounting principles are complex and require management to apply significant judgment to various accounting, reporting, and disclosure matters. Management must use assumptions, judgments and estimates when applying these principles where precise measurements are not possible or practical. These policies are critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such judgments, assumptions or estimates may have a significant impact on the consolidated financial statements. Actual results, in fact, could differ from initial estimates.

The accounting policies with the greatest uncertainty and that require our most difficult, subjective or complex judgments and the greatest likelihood that materially different amounts would be reported under different conditions, or using different assumptions, are our allowance for loan losses and our accounting for core deposit intangibles, both of which are described below.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS 5, "Accounting for Contingencies", which requires that losses be accrued when they are probable of occurring and are estimable and (ii) SFAS 114, "Accounting by Creditors for Impairment of a Loan", which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

Our allowance for loan losses has three basic components: the formula allowance, the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a historical loss view as an indicator of future losses and, as a result, could differ from the loss incurred in the future. However, since this history is updated with the most recent loss information, the errors that might otherwise occur are mitigated. The specific allowance uses various techniques to arrive at an estimate of loss. Historical loss information, expected cash flows and fair market value of collateral are used to estimate these losses. The use of these values is inherently subjective, and our actual losses could be greater or less than the estimates. The unallocated allowance captures losses that are attributable to various economic events and to industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized either in the formula or in the specific allowance.

Core Deposit Intangibles

Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets"(SFAS 142). Accordingly, goodwill is no longer subject to amortization over its estimated useful life, but is subject to at least an annual assessment for impairment by applying a fair value based test. Additionally, SFAS 142 requires that acquired intangible assets (such as core deposit intangibles) be separately recognized if the benefit of the asset can be sold, transferred, licensed, rented, or exchanged and amortized over its estimated useful life. Branch acquisition transactions were outside the scope of SFAS 142 and therefore any intangible asset arising from such transactions remained subject to amortization over its estimated useful life.

In October 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 147, "Acquisitions of Certain Financial Institutions"(SFAS 147). SFAS 147 amends previous interpretive guidance on the application of the purchase method of accounting to acquisitions of financial institutions, and requires the application of Statement of Financial Accounting Standards No. 141, "Business Combinations", and SFAS 142 to branch acquisitions if such transactions meet the definition of a business combination. The provisions of SFAS 147 do not apply to transactions between two or more mutual enterprises. In addition, SFAS 147 amends Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment of Long-Lived Assets", to include in its scope core deposit intangibles of financial institutions. Accordingly, such intangibles are subject to a recoverability test based on undiscounted cash flows, and to the impairment recognition and measurement provisions required for other long-lived assets held and used. The Company has determined that the acquisitions that generated the intangible assets on the consolidated balance sheets in the amount of $9,958 and $10,912 at December 31, 2003 and 2002, respectively, did not constitute the acquisition of a business, and therefore will continue to be amortized.

Overview

National Bankshares, Inc. (NBI) is a financial holding company incorporated under the laws of Virginia. Located in southwest Virginia, NBI has two wholly-owned subsidiaries, The National Bank of Blacksburg (NBB) and National Bankshares Financial Services, Inc. (NBFS). The National Bank of Blacksburg, which does business as National Bank from twenty-six office locations, is a community bank. NBB is the source of nearly all of the Company's revenue. National Bankshares Financial Services, Inc. does business as National Bankshares Investment Services and National Bankshares Insurance Services. Income from NBFS is not significant at this time, nor is it expected to be so in the near future.

Performance Summary



The following table shows NBI's key performance ratios for the three months
ended March 31, 2009 and year ended December 31, 2008.



                                                 March 31,    December 31,
                                                   2009           2008
         Return on average assets                      1.43 %          1.51 %
         Return on average equity                     12.14 %         12.52 %
         Net interest margin (1)                       4.08 %          4.12 %
         Noninterest margin (2)                        1.52 %          1.46 %
         Basic net earnings per share            $     0.49    $       1.96
         Fully diluted net earnings per share    $     0.49    $       1.96

(1) Net interest margin: Year-to-date tax-equivalent net interest income divided by year-to-date average earning assets.

(2) Noninterest margin: Noninterest income (excluding securities gains and losses) less noninterest expense (excluding the provision for bad debts and income taxes) divided by average year-to-date assets.

The return on average assets for the three months ended March 31, 2009 was 1.43%, a decline of 8 basis points from 1.51% for the year ended December 31, 2008, as internally generated asset growth increased at a faster rate than earnings. The return on average equity declined from 12.52% for the year ended December 31, 2008 to 12.14% for the three months ended March 31, 2009. Return on average equity declined because the Company's equity, mostly from retained earnings, grew at a faster rate than first quarter earnings. Although the net interest margin, at 4.08%, was 4 basis points lower than the 4.12% at year-end, it remained at a healthy level for the first quarter of 2009.

Growth



  The following table shows the Company's key growth indicators:




                       March 31, 2009     December 31, 2008     Percent Change
       Securities     $        300,491   $           264,999              13.39   %
       Loans, net              568,600               569,699              (0.19 ) %
       Deposits                857,829               817,848               4.89   %
       Total assets            979,787               935,374               4.75   %

Securities, deposits and total assets all grew in the first three months of 2009. Net loans remained essentially the same as at December 31, 2008. Growth in deposits came from municipalities and also from individual customers as they sought safety of principal while the value of other investment vehicles declined in volatile markets.

Asset Quality



  Key asset quality indicators are shown below:




                                           March 31, 2009     December 31,2008
     Nonperforming loans                    $        1,337     $          1,333
     Loans past due over 90 days                     1,607                1,127
     Other real estate owned                         1,918                1,984
     Allowance for loan losses to loans               1.06 %               1.02 %
     Net charge-off ratio                             0.08 %               0.09 %

Nonperforming loans at March 31, 2009, all of which were nonaccrual loans, were $1,337, or 0.23% of total loans. Nonperforming loans increased by $4 over the $1,333 reported on December 31, 2008. Loans past due 90 days or more at the end of the first quarter of 2009 were $1,607, up $480 from the total at year-end. Although there were modest increases in loans past due 90 days or more from year-end, the ratio of loans 90 days or more past due to total loans remains low when compared with peers and is consistent with the Company's conservative underwriting policies.

The Company has increased the allowance for loan losses to account for the higher potential risk in the loan portfolio that accompanies a recessionary environment. The ratio of the allowance for loan losses to loans increased from 1.02% at December 31, 2008 to 1.06% at March 31, 2009.

Net Interest Income

Net interest income for the first three months of 2009 was $8,166, an increase of $862, or 11.80%, when compared with the same period in 2008. This net increase is attributable to a decrease of $995 in interest expense, offset by a decrease in interest income of $133. The substantial decrease in interest expense was primarily caused by a decline in interest rates. In addition, management has focused on deposit pricing to maximize profitability.

The amount of net interest income earned is affected by various factors. These include changes in market interest rates due to the Federal Reserve Board's monetary policy, as well as the level and composition of the earning assets and interest-bearing liabilities. The Company has some ability to respond to interest rate movements and reduce volatility in the net interest margin. However, the frequency and magnitude of changes in market interest rates are difficult to predict, and these changes may have a greater impact on net interest income than any adjustments by management.

Interest rates are at historic lows, and low and stable interest rates benefit the Company. Offsetting the effect of low interest rates is the fact that some higher yielding securities in the Company's investment portfolio may be called when rates are low and are replaced with securities yielding at the lower market rate.

The primary source of funds used to support the Company's interest-earning assets is deposits. Deposits are obtained in the Company's trade area through traditional marketing techniques. Other funding sources, such as the Federal Home Loan Bank, while available, are only occasionally used. The cost of funds is dependent on interest rate levels and competitive factors. This limits the ability of the Company to react to interest rate movements.

If interest rates remain low and stable, management anticipates that there will be less pressure on the net interest margin as management is able to price loans and deposits rationally. If interest rates were to rise quickly, the net interest margin would narrow, because deposit rates would increase at a faster rate than loan rates. If interest rates rise more slowly, the negative effect on the net interest margin would be less pronounced.

Provision and Allowance for Loan Losses

The provision for loan losses for the three-month period ended March 31, 2009 was $370. The ratio of the allowance for loan losses to total loans at the end of the first three months of 2009 was 1.06%, which compares to 1.02% at December 31, 2008. The net charge-off ratio was 0.08% at March 31, 2009 and 0.09% at December 31, 2008.

During the first quarter of 2009, management added to the provision for loan losses in an amount management believes is sufficiently prudent given current economic conditions. Refer to the "Critical Accounting Policies" section of this report for more information related to the methodologies used to establish the Allowance for Loan Losses. The nonperforming loans total is made up of two loans, which management considers well-collateralized. Especially in this uncertain economic environment, loan quality indicators are closely monitored, and management regularly evaluates the sufficiency of the allowance for loan losses.

Noninterest Income



                                                 Three Months ended
                                        March 31, 2009        March 31, 2008      Percent Change
Service charges on deposit accounts   $              804    $              768                4.69   %
Other service charges and fees                        73                    84              (13.10 ) %
Credit card fees                                     625                   637               (1.88 ) %
Trust fees                                           276                   303               (8.91 ) %
Other income                                         249                   221               12.67   %
Realized securities gains                             80                   283              (71.73 ) %

Service charges on deposit accounts totaled $804 for the three months ended March 31, 2009. This is an increase of $36, or 4.69%, from the same period of 2008. This category is affected by the number of deposit accounts, the level of service charge fees and the number of checking account overdrafts. The growth resulted from an increase in the level of service charge fees.

Other service charges and fees includes charges for official checks, income from the sale of checks to customers, safe deposit rent, fees for letters of credit and the income earned from commission on the sale of credit life, accident and health insurance. These fees were $73 for the three months ended March 31, 2009 and $84 for the three months ended March 31, 2008.

A slightly lower volume of credit card accounts, transactions and merchant transactions resulted in credit card fees of $625 for the three months ended March 31, 2009. This was a decrease of $12, or 1.88%, when compared with the $637 total reported for the same period last year.

Trust fees, at $276, were down by $27, or 8.91%, from the $303 earned in the first quarter of 2008. Trust income varies depending on the number of Trust accounts, the types of accounts under management and financial market conditions. The decline in Trust fees is attributable to a combination of all three factors. The financial markets have declined significantly during 2008 and 2009, negatively affecting income. In addition, there are fewer accounts under management. The mix of account types also affected Trust fees during the quarter.

Other income is income that cannot be classified in another category. Some examples include net gains from the sales of fixed assets, rent from foreclosed properties, income from the increase in the cash value of life insurance and revenue from investment and insurance sales. Other income for the three months ended March 31, 2009 was $249. This represents an increase of $28, or 12.67%, when compared with the three months ended March 31, 2008.

During the first quarter of 2008, the Company recognized $290 in a one-time gain from the initial public offering of Visa, Inc. When the credit card processor went public, the Company was required to sell a portion of its Class B shares. This gain, offset by losses in called investment securities, was the source of the relative high level of realized securities gains for the three months ended March 31, 2008. Realized securities gains for the three months ended March 31, 2009 were $80, as compared with $283 for the same period in 2008.

Noninterest Expense



                                             Three Months ended
                                     March 31, 2009      March 31, 2008     Percent Change
Salaries and employee benefits         $       2,831       $       2,857              (0.91 ) %
Occupancy, furniture and fixtures                469                 456               2.85   %
Data processing and ATM                          322                 349              (7.74 ) %
Credit card processing                           463                 460               0.65   %

Intangibles amortization 278 284 (2.11 ) % Net costs of other real estate owned 60 14 328.57 % Other operating expenses 1,207 1,037 16.39 %

Salary and benefits expense decreased 0.91%, from $2,857 for the three months ended March 31, 2008 to $2,831 for the three months ended March 31, 2009. The Company has made a concerted effort to control these costs.

Occupancy, furniture and fixtures expense was $469 for the three months ended March 31, 2009, an increase of $13, or 2.85%, from the same period last year. The small increase reflects the Company's emphasis on containing controllable expenses.

Data processing and ATM expense was $322 for the three months ended March 31, 2009, a decrease of $27, or 7.74% from the three months ended March 31, 2008. In the first quarter of 2008, the Company had higher data processing costs associated with branch capture and merchant capture projects.

Credit card processing expense was $463 for the three months ended March 31, 2009, a slight increase of $3 from the total for the three months ended March 31, 2008. This expense is driven by volume and other factors such as merchant discount rates and is subject to a degree of variability.

The expense for intangibles and goodwill amortization is related to acquisitions. There were no acquisitions in the past year, and certain expenses have been fully amortized. This accounts for the decline from $284 for the three months ended March 31, 2008 to $278 for the three months ended March 31, 2009.

Net costs of other real estate owned have increased from $14 for the three months ended March 31, 2008 to $60 for the three months ended March 31, 2009. This expense category varies with the number of other real estate owned properties and the expenses associated with each, and it has increased in 2009 as the total of other real estate owned has grown.

The category of other operating expenses includes noninterest expense items such as franchise taxes, professional services, stationery and supplies, telephone costs, postage and charitable donations. Other operating expenses for the three months ended March 31, 2009 were $1,207. This reflects an increase of $170, or 16.39%, when compared with the same period in 2008.

The majority of the growth in other operating expenses is attributable to an increase of $100 in Federal Deposit Insurance Corporation Deposit Insurance Fund premiums. As the impact of the financial crisis on the banking industry worsens, this expense will increase in the future. FDIC has announced an emergency special assessment on insured banks, payable on June 30. However, this amount and terms of the assessment are still being discussed and have not yet been finalized.