Summary of COMMUNITY BANK SYSTEM INC

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

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 and six months ended June 30, 2009 and 2008, although in some circumstances the first quarter of 2009 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 21. 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, "second quarter" refers to the quarter ended June 30, 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 37.

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 and portfolio 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. An unrealized loss is generally deemed to be other-than-temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security. The credit loss component of an other-than-temporary impairment write-down is recorded in earnings, while the remaining portion of the impairment loss is recognized in other comprehensive income (loss), provided the Company does not intend to sell the underlying debt security and it is not more likely than not that the Company will be required to sell the debt security prior to recovery.

· 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 judgments 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 13%. 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.

Second quarter and June year-to-date 2009 net income of $9.2 million and $19.6 million, respectively, was $2.1 million or 18.9% and $2.6 million or 11.6% lower than the respective prior year periods. Earnings per share were $0.28 and $0.60 for the first three and six months of 2009, respectively, a decrease of $0.09 and $0.13, from the equivalent prior year periods. Higher operating expenses, principally from recently completed acquisitions, significantly higher FDIC insurance assessments and employee pension costs, and higher loan loss provisions were partially offset by higher net interest income generated through organic and acquired growth of both loans and core deposits, and higher noninterest income. Second quarter 2009's results included the incurrence of an additional $3.7 million of FDIC-insurance related assessments, or $0.09 per share above the second quarter of 2008. Excluding these additional assessments, earnings per share for the quarter were equal to the reported results from last year's second quarter.

Asset quality in the second quarter of 2009 remained stable and favorable, as compared to peer financial organizations. Loan charge-off and nonperforming loan ratios and the provision for loan losses were up versus the second quarter of 2008, but they improved from first quarter 2009 levels and continued to be below long-term historical levels. The delinquency ratio increased as compared to June 2008, but remains favorable compared to long-term historical levels. The Company experienced year-over-year loan growth in the consumer installment and business lending portfolios, due to organic and acquired growth. The investment portfolio, including cash equivalents, increased as compared to both the second quarter of 2008 and March 31, 2009 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 second quarter of 2009 as compared to both the first quarter of 2009 and the second quarter of 2008, reflective of the Citizens acquisition and organic growth in core deposits. External borrowings decreased from the second quarter of 2008 and remained consistent with the first quarter of 2009.

Net Income and Profitability

As shown in Table 1, net income for the second quarter and June YTD of $9.2 million and $19.6 million, respectively, declined 19% and 12% versus the comparable periods of 2008. Earnings per share for the quarter of $0.28 were down 24% over the second quarter of 2008 and earnings per share of $0.60 for the first six months of 2009 declined 18% from the amount earned in the first half of 2008. As compared to the first quarter of 2009, net income declined $1.3 million or 12.5% and earnings per share declined $0.04 or 12.5%.

Second quarter net interest income of $40.5 million was up $5.1 million or 14% from the comparable prior year period and net interest income for the first six months of 2009 increased $9.7 million or 14% over the first half of 2008. The current quarter's provision for loan losses increased $0.4 million as compared to the second quarter of 2008 and increased $2.5 million for the first six months of 2009 as compared to the same period of 2008, reflective of higher net charge-offs and the general deteriorating economic conditions. Second quarter noninterest income, excluding securities gains and losses, was $20.6 million, up $2.9 million or 17% from the second quarter of 2008, while year-to-date noninterest income of $41.0 increased $6.0 or 17% from the prior year level. Operating expenses of $47.5 million for the quarter and $91.9 million for the first six months of 2009 were up $10.5 million or 28% and $16.6 million or 22%, respectively, from the comparable prior year periods. A significant portion of the increase was attributable to the acquisitions of ABG and Citizens during the third and fourth quarters of 2008, as well as higher FDIC insurance assessments due to significant increases in premium rates and the special assessment in the second quarter, as well as the incurrence of higher pension related costs.

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 second quarter and year-to-date period increased as compared to the comparable periods of 2008 as a result of acquired and organic loan growth and increased levels of investments including cash equivalents, partially offset by a slightly lower net interest margin. 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 and year-to-date periods, 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 is as follows:

Table 1: Summary Income Statements

                                      Three Months Ended    Six Months Ended
                                           June 30,             June 30,
        (000's omitted, except per
        share data)                     2009      2008        2009     2008
        Net interest income             $40,514   $35,440    $80,700  $71,038
        Provision for loan losses         2,015     1,570      4,825    2,350
        Noninterest income
        excluding security
        gains/losses                     20,649    17,706     41,005   35,037
        (Loss) gain on sales of
        investment securities                 0      (57)          0      230
        Operating expenses               47,483    36,955     91,884   75,329
        Income before taxes              11,665    14,564     24,996   28,626
        Income taxes                      2,510     3,277      5,376    6,441
        Net income                       $9,155   $11,287    $19,620  $22,185

        Diluted earnings per share        $0.28     $0.37      $0.60    $0.73

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 2a, net interest income (with nontaxable income converted to a fully tax-equivalent basis) for the second quarter of 2009 was $44.4 million, a $5.2 million increase from the same period last year. A $599 million increase in second quarter interest-earning assets versus the prior year had a greater impact than the $505 million increase in average interest-bearing liabilities and a five-basis point decrease in the net interest margin. As reflected in Table 3, the volume increase from interest bearing assets and the rate decrease on interest bearing liabilities had a $16.2 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 lower yields on interest bearing assets had a greater unfavorable impact on net interest margin than the decrease in the cost of funding. June YTD net interest income of $88.6 million increased $9.9 million or 13% from the year-earlier period. A $563 million increase in interest bearing assets more than offset a $474 million increase in interest bearing liabilities and a two-basis point decrease in the net interest margin. The increase in interest earning assets and the lower rate on interest bearing liabilities had a $32.0 million favorable impact that was partially offset by a $22.1 million unfavorable impact from the decrease in rate on interest bearing assets and the increase in interest-bearing liability balances.

Higher second quarter and June year-to-date average loan balances were attributable to $113 million of organic loan growth since the second 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 second quarter loan balance was the $111 million of loans acquired in the Citizens acquisition and $12.9 million of growth at those branches since the date of acquisition. Average investments and cash equivalents for the second quarter and YTD periods were $363 million and $286 million higher than the respective periods 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 $625 million or 19% for the quarter primarily as a result of the November 2008 acquisition of Citizens. Second quarter average deposits from the Citizens acquisition were $583 million, as compared to $565 million at the date of acquisition. On an organic basis, average interest bearing deposits for the second quarter decreased slightly from the second quarter of 2008, a result of the Company's objective of lowering its overall funding costs by reducing higher cost time deposits. Organic growth in average noninterest bearing deposits was $42.1 million over the second quarter of 2008. Quarterly average borrowings decreased $11.2 million as compared to the second 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 3.73% for the second quarter and 3.77% for the year to date period decreased five basis points and two basis points, respectively, versus the same periods in the prior year. The decline was primarily attributable to a 72-basis point and a 69-basis point decrease in the earning asset yield for the quarter and year-to-date periods, respectively, as compared to the prior year periods. The decrease in the earning asset yield is due to a 114 basis point and 99 basis point decline in the investment yields for the second quarter and YTD periods, respectively and a 46 basis point and 52 basis point decline in the loan yields for the second quarter and YTD periods, respectively, as compared to the like periods in 2008. The change in the earning-asset yield is primarily 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.

Partially offsetting these declines was a 69-basis point and a 70-basis point decline in the cost of funds for the quarter and year-to-date periods, respectively, as compared to the same periods of 2008. The second quarter cost of funds decreased 69 basis points versus the prior year quarter due to a 90-basis point decrease in interest-bearing deposits rates and a six-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 half of 2009 in response to market conditions. Additionally, the proportion of customer deposits in higher cost time deposits has declined 6.5 percentage points over the last twelve months, while the percentage of deposits in non-interest bearing and lower cost checking 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.

Tables 2a and 2b 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 2a: Quarterly Average Balance Sheet

                                   Three Months Ended               Three Months Ended
                                     June 30, 2009                    June 30, 2008
                                                    Avg.                             Avg.
                              Average            Yield/Rate    Average            Yield/Rate
 (000's omitted except
yields and rates)             Balance   Interest    Paid       Balance   Interest    Paid
Interest-earning assets:
 Cash equivalents              $315,444     $202      0.26%      $29,138     $140      1.93%
 Taxable investment
securities (1)                  793,909    9,991      5.05%      750,820    9,775      5.24%
 Nontaxable investment
securities (1)                  558,278    9,379      6.74%      524,454    9,063      6.95%
 Loans (net of unearned
discount)                     3,105,247   46,248      5.97%    2,869,338   45,837      6.43%
   Total interest-earning
assets                        4,772,878   65,820      5.53%    4,173,750   64,815      6.25%
Noninterest-earning assets      540,396                          466,196
   Total assets              $5,313,274                       $4,639,946

Interest-bearing
liabilities:
 Interest checking, savings
and money market deposits    $1,802,845    2,863      0.64%   $1,304,146    2,519      0.78%
 Time deposits                1,379,982    9,224      2.68%    1,362,278   13,520      3.99%
 Short-term borrowings          593,533    6,347      4.29%      420,392    4,258      4.07%
 Long-term borrowings           265,169    3,007      4.55%      449,474    5,333      4.77%
   Total interest-bearing
liabilities                   4,041,529   21,441      2.13%    3,536,290   25,630      2.92%
Noninterest-bearing
liabilities:
 Demand deposits                671,615                          563,045
 Other liabilities               50,027                           51,167
Shareholders' equity            550,103                          489,444
   Total liabilities and
shareholders' equity         $5,313,274                       $4,639,946

Net interest earnings                    $44,379                          $39,185
Net interest spread                                   3.40%                            3.33%
Net interest margin on
interest-earnings assets                              3.73%                            3.78%

Fully tax-equivalent
adjustment                                $3,865                           $3,745

(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.

Table 2b: Year-to-Date Average Balance Sheet

                                    Six Months Ended                 Six Months Ended
                                     June 30, 2009                    June 30, 2008
                                                    Avg.                             Avg.
                              Average            Yield/Rate    Average            Yield/Rate
 (000's omitted except
yields and rates)             Balance   Interest    Paid       Balance   Interest    Paid
Interest-earning assets:
 Cash equivalents              $235,817     $298      0.26%      $36,933     $458      2.49%
 Taxable investment
securities (1)                  818,068   20,532      5.06%      757,527   20,492      5.44%
 Nontaxable investment
securities (1)                  558,809   18,958      6.84%      532,724   18,396      6.94%
 Loans (net of unearned
discount)                     3,122,788   93,156      6.02%    2,845,719   92,509      6.54%
   Total interest-earning
assets                        4,735,482  132,944      5.66%    4,172,903  131,855      6.35%
Noninterest-earning assets      538,997                          468,079
   Total assets              $5,274,479                       $4,640,982

Interest-bearing
liabilities:
 Interest checking, savings
and money market deposits    $1,747,305    5,914      0.68%   $1,282,540    5,234      0.82%
 Time deposits                1,405,921   19,743      2.83%    1,380,464   28,499      4.15%
 Short-term borrowings          535,680   11,275      4.24%      423,254    8,678      4.12%
 Long-term borrowings           324,680    7,422      4.61%      453,326   10,772      4.78%
   Total interest-bearing
liabilities                   4,013,586   44,354      2.23%    3,539,584   53,183      3.02%
Noninterest-bearing
liabilities:
 Demand deposits                661,512                          559,486
 Other liabilities               51,253                           55,815
Shareholders' equity            548,128                          486,097
   Total liabilities and
shareholders' equity         $5,274,479                       $4,640,982

Net interest earnings                    $88,590                          $78,672
Net interest spread                                   3.43%                            3.33%
Net interest margin on
interest-earnings assets                              3.77%                            3.79%

Fully tax-equivalent
adjustment                                $7,890                           $7,634

As discussed above and disclosed in Table 3 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 3: Rate/Volume
. . .