Introduction

This Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) primarily reviews the financial condition and results of operations of Community Bank System, Inc. (the Company or CBSI) as of and for the three months ended March 31, 2009 and 2008, although in some circumstances the fourth quarter of 2008 is also discussed in order to more fully explain recent trends. The following discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and related notes that appear on pages 3 through 17. All references in the discussion to the financial condition and results of operations are to those of the Company and its subsidiaries taken as a whole.

Unless otherwise noted, the term "this year" refers to results in calendar year 2009, "first quarter" refers to the quarter ended March 31, 2009, earnings per share (EPS) figures refer to diluted EPS, and net interest income and net interest margin are presented on a fully tax-equivalent (FTE) basis.

This MD&A contains certain forward-looking statements with respect to the financial condition, results of operations and business of the Company. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those proposed by such forward-looking statements are set herein under the caption, "Forward-Looking Statements," on page 32.

Critical Accounting Policies

As a result of the complex and dynamic nature of the Company's business, management must exercise judgment in selecting and applying the most appropriate accounting policies for its various areas of operations. The policy decision process not only ensures compliance with the latest generally accepted accounting principles ("GAAP"), but also reflects management's discretion with regard to choosing the most suitable methodology for reporting the Company's financial performance. It is management's opinion that the accounting estimates covering certain aspects of the business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity in the selection process. These estimates affect the reported amounts of assets and liabilities and disclosures of revenues and expenses during the reporting period. Actual results could differ from those estimates. Management believes that critical accounting estimates include:

· Allowance for loan losses - The allowance for loan losses reflects management's best estimate of probable losses inherent in the loan portfolio. Determination of the allowance is inherently subjective. It requires significant estimates including the amounts and timing of expected future cash flows on impaired loans and the amount of estimated losses on pools of homogeneous loans which is based on historical loss experience and consideration of current economic trends, all of which may be susceptible to significant change.

· Investment securities - Investment securities are classified as held-to-maturity, available-for-sale, or trading. The appropriate classification is based partially on the Company's ability to hold the securities to maturity and largely on management's intentions with respect to either holding or selling the securities. The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Unrealized gains and losses on available-for-sale securities are recorded in accumulated other comprehensive income or loss, as a separate component of shareholders' equity and do not affect earnings until realized. The fair values of the investment securities are generally determined by reference to quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments, or a discounted cash flow model using market estimates of interest rates and volatility. Marketable investment securities with significant declines in fair value are evaluated to determine whether they should be considered other-than -temporarily impaired. Impairment losses must be recognized in current earnings rather than in other comprehensive income or loss.

· Actuarial assumptions associated with pension, post-retirement and other employee benefit plans - These assumptions include discount rate, rate of future compensation increases and expected return on plan assets.

· Provision for income taxes - The Company is subject to examinations from various taxing authorities. Such examinations may result in challenges to the tax return treatment applied by the Company to specific transactions. Management believes that the assumptions and judgements used to record tax related assets or liabilities have been appropriate. Should tax laws change or the taxing authorities determine that management's assumptions were inappropriate, an adjustment may be required which could have a material effect on the Company's results of operations.

· Carrying value of goodwill and other intangible assets - The carrying value of goodwill and other intangible assets is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires use of a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums and company-specific risk indicators.

A summary of the accounting policies used by management is disclosed in Note A, "Summary of Significant Accounting Policies" on pages 49-54 of the most recent Form 10-K (fiscal year ended December 31, 2008) filed with the Securities and Exchange Commission on March 13, 2009.

Executive Summary

The Company's business philosophy is to operate as a community bank with local decision-making, principally in non-metropolitan markets, providing a broad array of banking and financial services to retail, commercial and municipal customers.

The Company's core operating objectives are: (i) grow the branch network, primarily through a disciplined acquisition strategy, and certain selective de novo expansions, (ii) build high-quality, profitable loan and deposit portfolios using both organic and acquisition strategies, (iii) increase the noninterest income component of total revenues through development of banking-related fee income, growth in existing financial services business units, and the acquisition of additional financial services and banking businesses, and (iv) utilize technology to deliver customer-responsive products and services and reduce operating costs.

Significant factors management reviews to evaluate achievement of the Company's operating objectives and its operating results and financial condition include, but are not limited to: net income and earnings per share, return on assets and equity, net interest margins, noninterest income, operating expenses, asset quality, loan and deposit growth, capital management, performance of individual banking and financial services units, liquidity and interest rate sensitivity, enhancements to customer products and services, technology advancements, market share, peer comparisons, and the performance of acquisition and integration activities.

On November 7, 2008, the Company acquired 18 branch-banking centers in northern New York from Citizens Financial Group, Inc. ("Citizens") in an all cash transaction. The Company acquired approximately $109 million in loans and $565 million in deposits at a blended deposit premium of 12%. The results of operations for the 18 branches acquired from Citizens have been included in the consolidated financial statements since that date. In support of the transaction, the Company raised approximately $50 million of equity capital in the form of common stock in October 2008.

On July 7, 2008, Benefit Plans Administrative Services, Inc. ("BPAS"), a wholly owned subsidiary of the company, acquired the Philadelphia division of Alliance Benefit Group MidAtlantic ("ABG") from BenefitStreet, Inc. in an all cash transaction. ABG provides retirement plan consulting, daily valuation administration, actuarial and ancillary support services. The results of ABG's operations have been included in the consolidated financial statements since that date.

First quarter net income of $10.5 million, or $0.32 per share decreased 11% or $0.04 from the $0.36 per share reported in the first quarter of 2008. Increased operating expenses, principally acquisition related, and significantly higher FDIC insurance assessments and a higher provision for loan losses resulted in the decrease. These were partially offset by higher net interest income generated through organic and acquired growth of both loans and core deposits, continued expansion of non-interest income sources, increased secondary market mortgage activity and a stable net interest margin. Cash earnings per share (which excludes the after-tax effect of the amortization of intangibles assets and acquisition-related market value adjustments) were $0.37 versus $0.41 for the prior year's first quarter.

Asset quality in the first quarter of 2009 remained stable and favorable, as compared to peer financial organizations, with increases in loan charge-off, delinquency and nonperforming loan ratios as well as a higher provision for loan losses versus the first quarter of 2008, but they continued to be below long-term historical levels. The Company experienced year-over-year loan growth in all portfolios: consumer installment, consumer mortgage and business lending, due to organic growth and the acquisition of Citizens. The investment portfolio, including cash equivalents, increased as compared to both the first quarter of 2008 and December 31, 2008 due to the net liquidity created from the acquisition of Citizens in the fourth quarter of 2008 and organic deposit growth. Average deposits increased in the first quarter of 2009 as compared to both the first and fourth quarters of 2008, reflective of the Citizens acquisition and growth in core deposits. External borrowings decreased from the end of December 2008 and the first quarter of 2008.

Net Income and Profitability

As shown in Table 1, net income for the quarter of $10.5 million declined 4.0% versus the first quarter of 2008. Earnings per share for the first quarter of $0.32 was $0.04 lower than the EPS generated in the same period of last year. First quarter net interest income of $40.2 million was up $4.6 million or 12.9% from the comparable prior year period. The current quarter's provision for loan losses increased $2.0 million as compared to the first quarter of 2008 and increased $0.4 million from the fourth quarter of 2008. First quarter noninterest income, excluding securities gains and losses, was $20.4 million, up $3.0 million or 17% from the first quarter of 2008. Operating expenses of $44.4 million for the quarter were up $6.0 million or 16% from the comparable prior year period, a significant portion of the increase was attributable to the acquisitions of ABG and Citizens during the second and fourth quarters of 2008, as well as higher FDIC insurance assessments due to significant increases in premium rates and the incurrence of higher pension costs.

In addition to the earnings results presented above in accordance with generally accepted accounting principles (GAAP), the Company provides cash earnings per share, which excludes the after-tax effect of the amortization of intangible assets and acquisition-related market value adjustments. Management believes that this information helps investors better understand the effect of acquisition activity in reported results. Cash earnings per share for the first quarter of 2009 was $0.37, down 9.8% from the $0.41 earned in the comparable period of 2008.

As reflected in Table 1, the primary reasons for lower earnings were higher operating expenses and loan loss provision, partially offset by higher noninterest income and net interest income. Net interest income for the first quarter of 2009 increased as compared to the first quarter of 2008 as a result of a slightly higher net interest margin as well as acquired and organic loan growth. Excluding security gains and losses, noninterest income increased due to increased activity in the secondary mortgage banking business, growth in the Company's employee benefits consulting and plan administration business, mostly as a result of the acquisition of ABG, as well as higher banking service fees and debit card related revenues from the acquired branches. Higher net charge-offs and an increase in total loans outstanding were the primary reasons for the increase in loan loss provision. Operating expenses increased for the quarter as compared to the prior year, primarily due to costs associated with the two acquisitions in the last year, as well as higher FDIC insurance assessments and higher pension costs related to the underlying asset performance in 2008.

A condensed income statement and a reconciliation of GAAP-based earnings results to cash-based earnings results are as follows:

Table 1: Summary Income Statements

                                                        Three Months Ended
                                                             March 31,
        (000's omitted, except per share data)            2009      2008
        Net interest income                               $40,186   $35,598
        Provision for loan losses                           2,810       780
        Noninterest income, excluding security losses      20,356    17,331
        Gain on sales of investment securities                  0       287
        Operating expenses                                 44,401    38,374
        Income before taxes                                13,331    14,062
        Income taxes                                        2,866     3,164
        Net income                                        $10,465   $10,898

        Diluted earnings per share                          $0.32     $0.36

Table 2: Reconciliation of GAAP Net Income to Cash Net Income (Non-GAAP measure)

                                                      Three Months Ended
                                                           March 31,
          (000's omitted)                               2009      2008
          Net income                                    $10,465   $10,898
          After-tax cash adjustments:
           Amortization of market value adjustments
             on net assets acquired in mergers               53       156
           Amortization of intangible assets              1,653     1,187
          Net income - cash                             $12,171   $12,241

          Diluted earnings per share - cash               $0.37     $0.41

Net Interest Income

Net interest income is the amount by which interest and fees on earning assets (loans, investments and cash) exceed the cost of funds, primarily interest paid to the Company's depositors and interest on external borrowings. Net interest margin is the difference between the gross yield on earning assets and the cost of interest-bearing funds as a percentage of earning assets.

As shown in Table 3, net interest income (with nontaxable income converted to a fully tax-equivalent basis) for the first quarter of 2009 was $44.2 million, a $4.7 million increase from the same period last year and was consistent with the fourth quarter of 2008. A $526 million increase in first quarter interest-earning assets and a one basis point increase in the net interest margin versus the prior year had a greater impact than the $442 million increase in average interest-bearing liabilities. As reflected in Table 4, the volume increase from interest bearing assets and the rate decrease on interest bearing liabilities had a $15.7 million favorable impact on net interest income, while the volume increase from interest bearing liabilities and rate decrease on interest bearing assets had a $11.0 million unfavorable impact on net interest income. The decrease in the cost of funding had a slightly greater favorable impact on net interest margin than the lower yields on interest bearing assets.

Higher first quarter average loan balances were attributable to $201 million of organic loan growth since the first quarter of 2008, driven by growth in all portfolios: consumer installment, consumer mortgage and business lending. The remaining contribution to the increase in the average first quarter loan balance was the $117 million of loans acquired in the Citizens acquisition. Average investments and cash equivalents for the first quarter period were $207 million higher than the respective period of 2008, reflective of the net liquidity generated from the Citizens acquisition and organic deposit growth. In comparison to the prior year, total average deposits were up $559 million or 17% for the quarter as a result of the November 2008 acquisition of Citizens. First quarter average deposits from the Citizens acquisition were $565 million. On an organic basis, average deposits for the first quarter decreased $5.7 million from the first quarter of 2008, as a result of the Company's objective of lowering its overall funding costs by reducing higher cost time deposits. Quarterly average borrowings decreased $21 million as compared to the first quarter of 2008 as a portion of the net liquidity from the branch acquisition was used to eliminate short-term borrowings.

The net interest margin of 3.82% for the first quarter increased one basis point versus the same period in the prior year. The improvement was primarily attributable to a 70-basis point decrease in the cost of funds, driven by a 75-basis point drop in the cost of deposit funding and a nine-basis point decline in the cost of external borrowings. Partially offsetting these improvements was a 67-basis point decline in the earning asset yield for the quarter as compared to the first quarter of 2008. The change in the earning-asset yield was driven by a 59-basis point decrease in loan yields for the quarter and an 80-basis point decline in the investment yields for the quarter, mostly as a result of variable and adjustable-rate loans repricing downward due to the decline in interest rates, as well as the Company's increased holdings of lower yielding cash instruments as it maintains a liquid position in anticipation of improved investment opportunities in future periods.

The first quarter cost of funds decreased 70 basis points versus the prior year quarter due to a 75-basis point decrease on interest-bearing deposits rates and a nine-basis point decrease in the average interest rate paid on external borrowings. The decreased cost of funds was reflective of disciplined deposit pricing, whereby interest rates on selected categories of deposit accounts were lowered throughout 2008 and the first quarter of 2009 in response to market conditions. Additionally, the proportion of customer deposits in higher cost time deposits has declined 6.0 percentage points over the last twelve months, while the percentage of deposits in lower cost checking and savings accounts has increased. The rate paid on long-term borrowings was impacted by the approximately 200 basis point decrease in the three-month LIBOR (London Interbank Offered Rates) over the last twelve months, from which the interest rate on $25 million of the mandatorily redeemable preferred securities is based.

Table 3 below sets forth information related to average interest-earning assets and interest-bearing liabilities and their associated yields and rates for the periods indicated. Interest income and yields are on a fully tax-equivalent basis using marginal income tax rates of 38.46% in 2009 and 38.49% in 2008. Average balances are computed by accumulating the daily ending balances in a period and dividing by the number of days in that period. Loan yields and amounts earned include loan fees. Average loan balances include nonaccrual loans and loans held for sale.

Table 3: Quarterly Average Balance Sheet

                                      Three Months Ended               Three Months Ended
(000's omitted except yields
and rates)                              March 31, 2009                   March 31, 2008
                                                       Avg.                             Avg.
                                 Average            Yield/Rate    Average            Yield/Rate
                                 Balance   Interest    Paid       Balance   Interest    Paid
Interest-earning assets:
 Cash equivalents                 $155,306      $96      0.25%      $44,728     $318      2.86%
 Taxable investment securities
(1)                                842,496   10,541      5.07%      764,234   10,717      5.64%
 Nontaxable investment
securities (1)                     559,344    9,579      6.95%      540,993    9,334      6.94%
 Loans (net of unearned
discount)                        3,140,524   46,908      6.06%    2,822,100   46,672      6.65%
   Total interest-earning
assets                           4,697,670   67,124      5.79%    4,172,055   67,041      6.46%
Noninterest-earning assets         537,582                          469,964
   Total assets                 $5,235,252                       $4,642,019

Interest-bearing liabilities:
 Interest checking, savings and
money market deposits           $1,691,147    3,051      0.73%   $1,260,934    2,714      0.87%
 Time deposits                   1,432,149   10,519      2.98%    1,398,650   14,980      4.31%
 Short-term borrowings             477,184    4,928      4.19%      426,116    4,419      4.17%
 Long-term borrowings              384,852    4,415      4.65%      457,177    5,440      4.79%
   Total interest-bearing
liabilities                      3,985,332   22,913      2.33%    3,542,877   27,553      3.13%
Noninterest-bearing
liabilities:
 Demand deposits                   651,298                          555,927
 Other liabilities                  52,490                           60,465
Shareholders' equity               546,132                          482,750
   Total liabilities and
shareholders' equity            $5,235,252                       $4,642,019

Net interest earnings                       $44,211                          $39,488
Net interest spread                                      3.46%                            3.33%
Net interest margin on
interest-earnings assets                                 3.82%                            3.81%

Fully tax-equivalent adjustment              $4,025                           $3,890

(1) Averages for investment securities are based on historical cost basis and the yields do not give effect to changes in fair value that is reflected as a component of shareholders' equity and deferred taxes.

As discussed above and disclosed in Table 4 below, the quarterly change in net interest income (fully tax-equivalent basis) may be analyzed by segregating the volume and rate components of the changes in interest income and interest expense for each underlying category.

                              Table 4: Rate/Volume

                                             1st Quarter 2009 versus 1st Quarter
                                                             2008
                                             Increase (Decrease) Due to Change in
                                                             (1)
                                               Volume       Rate      Net Change
(000's omitted)
Interest earned on:
 Cash equivalents                                   $262       ($484)       ($222)
 Taxable investment securities                     1,040      (1,216)        (176)
 Nontaxable investment securities                    314         (69)          245
 Loans (net of unearned discount)                  4,992      (4,756)          236
Total interest-earning assets (2)                  7,948      (7,865)           83

Interest paid on:
 Interest checking, savings and money
market deposits                                      825        (488)          337
 Time deposits                                       351      (4,812)      (4,461)
 Short-term borrowings                               528         (19)          509
 Long-term borrowings                              (836)        (189)      (1,025)
Total interest-bearing liabilities (2)             3,150      (7,790)      (4,640)

Net interest earnings (2)                         $4,947       $(224)       $4,723

(1) The change in interest due to both rate and volume has been allocated in proportion to the relationship of the absolute dollar amounts of such change in each component.

(2) Changes due to volume and rate are computed from the respective changes in average balances and rates and are not a summation of the changes of the components.

Noninterest Income

The Company's sources of noninterest income are of three primary types: 1) general banking services related to loans, deposits and other core customer activities typically provided through the branch network and electronic banking channels (performed by Community Bank, N.A. and First Liberty Bank and Trust);
2) employee benefit plan administration, actuarial and consulting services (performed by BPAS); and 3) wealth management services, comprised of trust services (performed by the trust unit within CBNA), investment and insurance products (performed by Community Investment Services, Inc. or CISI and CBNA Insurance Agency, Inc.) and asset management (performed by Nottingham Advisors or Nottingham). Additionally, the Company has periodic transactions, most often net gains (losses) from the sale of investment securities and prepayment of debt instruments.

                          Table 5: Noninterest Income

                                                     Three Months Ended
                                                          March 31,
           (000's omitted)                             2009      2008
           Deposit service charges and fees             $9,018    $8,261
           Benefit plan administration, consulting
              and actuarial fees                         7,007     6,312
           Wealth management services                    2,033     2,163
           Other banking services                          280       373
           Mortgage banking                              2,018       222
              Subtotal                                  20,356    17,331
           Gain on sales of investment securities            0       287
              Total noninterest income                 $20,356   $17,618

           Noninterest income/total income (FTE)         31.5%     30.5%

As displayed in Table 5, noninterest income (excluding securities gains) was $20.4 million in the first quarter, an increase of $3.0 million or 17% from the prior year level. A significant portion of the growth was attributable to higher residential mortgage banking revenues, which grew to $2.0 million in the first quarter of 2009 from $0.2 million in the year earlier period. Residential mortgage banking income consists of realized gains or losses from the sale of residential mortgage loans and the origination of mortgage loan servicing rights, unrealized gains and losses on residential mortgage loans held for sale and related commitments, mortgage loans servicing fees and other mortgage . . .