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) and other financial reform legislation,

• unanticipated increases in the level of unemployment in the Company's trade area,

• 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, which have contributed to a severe global recession. While the Company has not been significantly negatively impacted during the recent economic crisis, a severe and prolonged downturn in the economy 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. The Company's markets to date have not been dramatically affected by the large declines in real estate values that have affected other geographic areas of the country. Therefore, the Company has not experienced significant write-downs of asset values. If the recession results in unanticipated increases in the rate of unemployment in the Company's trade area, there could be an adverse effect on the level of the Company's loan delinquencies and an increase in real estate foreclosures. 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. Although there have been some recent encouraging signs of economic recovery, 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. A deep and 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-five 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.

National Bankshares, Inc. common stock is listed on the NASDAQ Capital Market and is traded under the symbol "NKSH." On June 29, 2009, National Bankshares, Inc. was included in the Russell Investments Russell 3000 and Russell 2000 Indexes. The Russell 3000 Index, which is reconstituted annually, is made up of the 3,000 largest U.S. Companies, as calculated using market capitalization. The Russell 2000 is the subset of the Russell 3000 that represents the small cap portion of the Index. Inclusion in the Russell Index may help raise awareness of the Company among institutional investors and the investment community.

Performance Summary



The following table shows NBI's key performance ratios for the six months ended
June 30, 2009 and year ended December 31, 2008.



                                                  June 30,    December 31,
                                                    2009          2008
          Return on average assets                     1.40 %          1.51 %
          Return on average equity                    11.92 %         12.52 %
          Net interest margin (1)                      4.09 %          4.12 %
          Noninterest margin (2)                       1.58 %          1.46 %
          Basic net earnings per share            $    0.97    $       1.96
          Fully diluted net earnings per share    $    0.97    $       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 six months ended June 30, 2009 was 1.40%, a decline of 11 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 11.92% for the six months ended June 30, 2009. Return on average equity declined because the Company's equity, mostly from retained earnings, grew at a faster rate than earnings. As discussed below, higher costs for Federal Deposit Insurance Corporation Deposit Insurance Fund premiums had a negative effect on the Company's earnings for the first six months in 2009. The total of FDIC premiums for the first two quarters of 2009 was $1,006, as compared with $43 for the same period of 2008. In the second quarter of 2009, the total of FDIC premiums was $885, as compared with $22 in the second quarter of 2008. The net interest margin, at 4.09%, was 3 basis points lower than the 4.12% at year-end. Despite the slight decline, the net interest margin remained at a healthy level for the second quarter of 2009.

Although the net interest margin of 4.09% at June 30, 2009 remained healthy and underlying earnings were strong, the Company's earnings for the second quarter of 2009 were negatively affected by a significant increase in Federal Deposit Insurance Corporation Deposit Insurance Fund premiums. The FDIC imposed a special assessment of five basis points of total NBB assets less Tier 1 Capital at June 30, 2009. The special assessment was imposed to increase the Deposit Insurance Fund's reserve ratio, which has been impacted by an increased number of bank failures. In addition, because of higher deposit totals and because FDIC utilized a new premium calculation formula, NBB had a higher level of regular quarterly Deposit Insurance Fund premiums in the second quarter of 2009.

Growth



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




                        June 30, 2009     December 31, 2008     Percent Change
        Securities     $       306,283   $           264,999              15.58   %
        Loans, net             569,852               569,699               0.03   %
        Deposits               861,862               817,848               5.38   %
        Total assets           984,762               935,374               5.28   %

Securities, deposits and total assets all grew in the first six 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 and avoided more volatile market investments.

Asset Quality



  Key asset quality indicators are shown below:




                                            June 30, 2009     December 31,2008
      Nonperforming loans                    $       2,729     $          1,333
      Loans past due 90 days or more                 1,746                1,127
      Other real estate owned                        1,869                1,984
      Allowance for loan losses to loans              1.09 %               1.02 %
      Net charge-off ratio                            0.08 %               0.09 %

Nonperforming loans at June 30, 2009, all of which were nonaccrual loans, were $2,729, or 0.47% of loans net of unearned income. Nonperforming loans increased by $1,396 over the $1,333 reported on December 31, 2008. Loans past due 90 days or more at the end of the second quarter of 2009 were $1,746, up $619 from the total at year-end and were 0.30% of loans net of unearned income. Although the totals of nonperforming loans and loans past due 90 days or more have grown when compared with year-end, the ratio of both to total loans remained low when compared with peers and is consistent with the Company's conservative underwriting policies. If the economic downturn worsens in the Company's market area, it is realistic to expect further increases in nonperforming and past due loans.

The Company has increased the allowance for loan losses to account for growth in the loan portfolio, the increase in nonperforming loans and 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 1.09% at June 30, 2009.

Net Interest Income

Net interest income for the first six months of 2009 was $16,603, an increase of $1,642, or 10.98%, when compared with the same period in 2008. This net increase is attributable to a decrease of $1,536 in interest expense and an increase in interest income of $106. As compared with the first six months of 2008, the lower interest rate environment in the first half of 2009 caused the Company's yield on earning assets to decline. However, a higher volume of earning assets resulted in the $106 increase in total interest income for the six months ended June 30, 2009. Despite an increase in total deposits when June 30, 2009 and June 30, 2008 are compared, as noted above, total interest expense dropped by $1,536. This decline is attributable to a combination of lower interest rates and the Company's conservative deposit pricing.

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 continue 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 six-month period ended June 30, 2009 was $648. The ratio of the allowance for loan losses to total loans at the end of the second three months of 2009 was 1.09%, which compares to 1.02% at December 31, 2008. The net charge-off ratio was 0.08% at June 30, 2009 and 0.09% at December 31, 2008.

During the second quarter of 2009, management added to the provision for loan losses in an amount it believed was 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 five nonaccrual loans, all of which have unliquidated collateral associated with them. 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



                                                Six Months ended
                                        June 30, 2009       June 30, 2008      Percent Change
Service charges on deposit accounts   $           1,641   $           1,572                4.39   %
Other service charges and fees                      156                 162               (3.70 ) %
Credit card fees                                  1,337               1,373               (2.62 ) %
Trust fees                                          537                 622              (13.67 ) %
Bank owned life insurance income                    353                 303               16.50   %
Other income                                        185                 226              (18.14 ) %
Realized securities gains                            70                 265              (73.58 ) %

Service charges on deposit accounts totaled $1,641 for the six months ended June 30, 2009. This is an increase of $69, or 4.39%, 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. Of the $69 increase in service charges on deposit accounts, $57 is attributable to higher account overdraft and ATM fees. These fees were increased in late 2008.

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 $156 for the six months ended June 30, 2009, down by 3.70% from $162 for the six months ended June 30, 2008.

Credit card fees for the first six months of 2009 were $1,337. This was a decrease of $36, or 2.62%, when compared with the $1,373 total reported for the same period last year. Merchant transaction fees declined by $37 and credit card fees were $12 lower when the two periods are compared. This was offset by a $13 increase in fees attributable to debit card usage.

Trust fees, at $537, were down by $85, or 13.67%, from the $622 earned in the second 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.

Noninterest income from bank owned life insurance increased $50, or 16.50%, to $353 for the six months ended June 30, 2009. The increase is due to an additional purchase of insurance in mid-2008.

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 and revenue from investment and insurance sales. Other income for the six months ended June 30, 2009 was $185. This represents a decrease of $41, or 18.14%, when compared with the six months ended June 30, 2008. A substantial portion of the decline in other income comes from a $26 drop in NBFS income, when the first six months of 2008 and 2009 are compared. In addition, there was a $9 gain from the sale of repossessed automobiles in the first six months of 2008 that was not repeated in the same period in 2009.

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 six months ended June 30, 2008. Realized securities gains for the six months ended June 30, 2009 were $70, as compared with $265 for the same period in 2008. Realized securities gains in 2009 have come solely from gains in called securities.

Noninterest Expense



                                               Six Months ended
                                        June 30, 2009     June 30, 2008     Percent Change
Salaries and employee benefits           $       5,625     $       5,603                0.39   %
Occupancy, furniture and fixtures                  894               891                0.34   %
Data processing and ATM                            636               678               (6.19 ) %
FDIC insurance                                   1,006                43            2,239.53   %
Credit card processing                           1,001             1,024               (2.25 ) %
Intangibles amortization                           551               562               (1.96 ) %
Net costs of other real estate owned                71                12              491.67   %
Franchise taxes                                    445               411                8.27   %
Other operating expenses                         1,581             1,539                2.99   %

Salary and benefits expense increased $22, or 0.39%, from $5,603 for the six months ended June 30, 2008 to $5,625 for the six months ended June 30, 2009. The Company has made a concerted effort to control salary costs.

Occupancy, furniture and fixtures expense was $894 for the six months ended June 30, 2009, an increase of $3, or 0.34%, from the same period last year. The small increase reflects the Company's emphasis on containing controllable expenses. On June 30, 2009, NBB consolidated its Fincastle branch office in Tazewell, Virginia with a nearby office. The Fincastle Office was located in a larger building which had housed operations functions which were previously consolidated at NBB's Hethwood Operations Center in Blacksburg, Virginia or which had been replaced by branch capture. Employees at the Fincastle Office were reassigned to other locations. The Company does not expect to realize immediate and meaningful cost savings from the closing of the Fincastle Office, but expects that it will result in future expense reduction.

Data processing and ATM expense was $636 for the six months ended June 30, 2009, a decrease of $42, or 6.19% from the six months ended June 30, 2008. During the first half of 2008, the Company had higher data processing costs associated with branch capture and merchant capture projects.

As previously discussed, when June 30, 2008 and June 30, 2009 are compared, there was a significant increase in premiums for the Federal Deposit Insurance Corporation Deposit Insurance Fund. The total for the first six months last year was $43. This compares with $1,006 for the same period in 2009. The increase is a combination of an FDIC special assessment of five basis points of total NBB assets less Tier 1 Capital on June 30, 2009, and a higher level of regular quarterly premiums. The FDIC has published a final rule which allows it to impose additional special assessments of 5 basis points for the third and fourth quarters, if the FDIC estimates that the Deposit Insurance Fund reserve ratio falls to a level that would negatively affect public confidence in federal deposit insurance.

Credit card processing expense was $1,001 for the six months ended June 30, 2009, a decrease of $23, or 2.25% from the total for the six months ended June 30, 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 $562 for the six months ended June 30, 2008 to $551 for the six months ended June 30, 2009.

. . .