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") for the past two years, although in some circumstances a period longer than two years is covered in order to comply with Securities and Exchange Commission disclosure requirements or to more fully explain long-term trends. The following discussion and analysis should be read in conjunction with the Selected Consolidated Financial Information on page 15 and the Company's Consolidated Financial Statements and related notes that appear on pages 43 through 76. All references in the discussion to the financial condition and results of operations are to the consolidated position and results of the Company and its subsidiaries taken as a whole.

Unless otherwise noted, all earnings per share ("EPS") figures disclosed in the MD&A refer to diluted EPS; interest income, net interest income and net interest margin are presented on a fully tax-equivalent ("FTE") basis. The term "this year" and equivalent terms refer to results in calendar year 2008, "last year" and equivalent terms refer to calendar year 2007, and all references to income statement results correspond to full-year activity unless otherwise noted.

This Management's Discussion and Analysis of Financial Condition and Results of Operations contains certain forward-looking statements with respect to the financial condition, results of operations and business of Community Bank System, Inc. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements are set herein under the caption "Forward-Looking Statements" on page 40.

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 on 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 the critical accounting estimates include:

· Allowance for loan losses - The allowance for loan losses reflects management's best estimate of probable loan losses in the Company's loan portfolio. Determination of the allowance for loan losses 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. Specific discussion of the assumptions used by management is discussed in Note K on pages 65 through 68.

· 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 them to select 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", starting on page 49.

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 profitable loan and deposit volume using both organic and acquisition strategies, (iii) increase the non-interest 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 to 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, performance of specific product lines, 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.

The Company's reported net income for the year of $45.9 million, or $1.49 per share, was 7.1% above 2007's reported earnings of $42.9 million, or $1.42 per share. The 2008 results were driven by strong organic loan and core deposit growth, continued expansion of non-interest revenues, improved net interest margin, and continued solid asset quality. The Company also recorded a $1.7 million benefit related to a change in certain previously unrecognized tax positions. These results were partially offset by a $1.7 million non-cash charge for impairment of goodwill associated with one of the Company's wealth management businesses, as well as $1.4 million of acquisition expenses related to the purchase of 18 branch-banking centers in northern New York State from Citizens in November and the purchase of ABG in July. Last year's results included a $6.9 million benefit related to the settlement and a related change in certain previously unrecognized tax positions, and a $9.9 million pretax charge related to the early redemption of $25 million of variable-rate, trust preferred obligations, and the refinancing of $150 million of Federal Home Loan Bank advances into lower cost instruments.

Asset quality remained favorable in 2008, with increases in the loan charge-off, delinquency and nonperforming loan ratios as well as a higher provision for loan losses versus 2007, but still 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 both the Citizens branch acquisition and strong organic loan growth. The investment portfolio, including cash equivalents, increased from the prior year due to the net liquidity created from the acquisition of Citizens' branches in the fourth quarter. Average deposits increased in 2008 as compared to 2007 as the result of the acquisition of Citizens' branches as well as organic growth in core product relationships, offset by a reduction in time deposits. External borrowings decreased from the end of December 2007 as a portion of the net liquidity from the branch acquisition was used to eliminate short-term obligations.

While the Company reported improved earnings for 2008, it anticipates that current global economic conditions and challenges in the financial services industry may negatively impact earnings in 2009. In particular, the Company expects that in 2009: (1) premiums paid to the FDIC will increase significantly,
(2) pension and postretirement expenses will increase significantly, (3) revenue from FHLB dividends may decrease, (4) payments representing interest and principal on currently outstanding loans and investments will most likely be reinvested at rates that are lower than the rates on currently outstanding loans and investments and (5) the economy may have an adverse affect on asset quality indicators and the provision for loan losses, and therefore credit costs, which have trended higher in 2008, are not expected to decline until economic indicators improve. Due to current uncertainty in economic conditions and the financial services industry in general, it is particularly difficult to estimate certain revenue, expenses, and other related matters. There may be factors in addition to those identified above that impact 2009 results. For a discussion of risks and uncertainties that could impact the Company's future results, see Item 1A. Risk Factors.

Net Income and Profitability

Net income for 2008 was $45.9 million, up $3.0 million, or 7.1%, from 2007's earnings of $42.9 million. Earnings per share for 2008 was $1.49 per share, up 4.9% from 2007's earnings per share. The 2008 results include a $1.7 million or $0.05 per share benefit related to a change in a position taken on certain previously unrecognized tax positions. The 2008 results also include a $1.7 million or $0.04 per share non-cash charge for impairment of goodwill associated with the Company's wealth management business and $1.4 million or $0.03 per share of acquisition expenses related to the purchase of 18 branch-banking centers in northern New York Sate from Citizens in November and the purchase of ABG in July.

In addition to the earnings results presented above in accordance with GAAP, the Company provides cash earnings per share which excludes the after-tax effect of the amortization of intangible assets, the market value adjustments on net assets acquired in mergers, and the noncash portion of debt extinguishments costs. Management believes that this information helps investors understand the effect of acquisition activity and certain noncash transactions in reported results. Cash earnings per share for 2008 were $1.73, up 6.8% from $1.62 for the year ended December 31, 2007.

Net income and earnings per share for 2007 were $42.9 million and $1.42, up 12% from 2006 results. The 2007 results include a $9.9 million, or $0.20 per share, pre-tax charge related to the early redemption of $25 million of variable-rate, trust preferred obligations, as well as the refinancing of $150 million of Federal Home Loan Bank advances into lower cost instruments. The 2007 results also included a $6.9 million, or $0.23 per share, benefit related to the settlement and a related change in a position taken on certain previously unrecognized tax positions. The 2006 earnings included a $2.4 million, or $0.06 per share, charge related to the early redemption of fixed rate, trust-preferred obligations.

Table 1: Condensed Income Statements

                                                  Years Ended December 31,
 (000's omitted, except per share data)   2008     2007     2006     2005     2004
 Net interest income                    $148,507 $135,974 $134,809 $143,872 $151,095
 Loan loss provision                       6,730    2,004    6,585    8,534    8,750
 Noninterest income                       73,474   53,286   49,276   60,596   44,393
 Operating expenses                      158,562  142,074  127,203  127,389  119,899
 Income before taxes                      56,689   45,182   50,297   68,545   66,839
 Income taxes                             10,749    2,291   11,920   17,740   16,643
 Net income                              $45,940  $42,891  $38,377  $50,805  $50,196

 Diluted earnings per share                $1.49    $1.42    $1.26    $1.65    $1.64
 Diluted earnings per share-cash(1)        $1.73    $1.62    $1.47    $1.84    $1.81

(1) Cash earnings are reconciled to GAAP net income in Table 2.

Table 2: Reconciliation of GAAP Net Income To Non-GAAP Cash Net Income

                                                Years Ended December 31,
    (000's omitted)                       2008    2007    2006    2005    2004
    Net income                           $45,940 $42,891 $38,377 $50,805 $50,196
    After-tax adjustments:
      Net amortization of market value
    adjustments on net assets acquired
    in mergers                               509     701     813     655   (126)
      Amortization of intangible assets    5,379   4,808   4,598   5,281   5,568
      Noncash portion of debt
    extinguishments charge                     0     466     794       0       0
      Impairment of goodwill               1,360       0       0       0       0
    Net income - cash                    $53,188 $48,866 $44,582 $56,741 $55,638

The primary factors explaining 2008 performance are discussed in detail in the remaining sections of this document and are summarized as follows:

· As shown in Table 1 above, net interest income increased $12.5 million, or 9.2%, due to a $144 million increase in average earning assets and an 18 basis point increase in the net interest margin. Average loans grew $191 million or 7.0%, primarily due to strong business lending, consumer installment and retail mortgage growth as well as the addition of 18 branch banking centers in November 2008, and TLNB in June 2007. Average investments decreased $6.8 million, or 0.5% in 2008. Short-term cash equivalents also decreased $40.4 million as compared to 2007. Average borrowings increased $81.4 million due to the need to supplement the funding of strong organic loan growth and provide temporary financing for investment purchases made in advance of the significant amount of liquidity that was provided by the Citizens acquisition.

· The loan loss provision of $6.7 million increased $4.7 million, or 236%, from the prior year level. Net charge-offs of $5.7 million increased by $3.1 million from 2007, increasing the net charge-off ratio (net charge-offs / total average loans) to 0.20% for the year. The Company's asset quality remained strong as key metrics such as nonperforming loans as a percentage of total loans, nonperforming assets as a percentage of loans and other real estate owned, and delinquent loans (30+ days through nonaccruing) as a percentage of total loans increased but remained below long-term historical levels. Additional information on trends and policy related to asset quality is provided in the asset quality section on pages 31 through 34.

· Noninterest income for 2008 of $73.5 million increased by $20.2 million, or 38%, from 2007's level, due both to organic growth and the acquisitions of the Citizens' branches, ABG, HBT and TLNB. Noninterest income for 2007 included a $9.9 million debt refinancing charge, comprised of the refinance of certain Federal Home Loan Bank advances and the early redemption of $25 million of trust preferred securities. Fees from banking services were up $3.5 million or 10%, primarily due to several revenue enhancement initiatives implemented over the last two years, as well as the acquisitions completed in 2008 and 2007. Financial services revenue was up $6.5 million, or 23% higher, mostly from strong growth at the Company's benefit plan administration and consulting business and the acquisition of ABG and HBT.

· Total operating expenses increased $16.5 million or 11.6% in 2008 to $158.6 million. A significant portion of the increase was primarily attributable to incremental operating expenses related to the Citizens' branches, ABG, TLNB and HBT acquisitions. Additionally, expenses were up due to annual merit and other personnel costs, higher FDIC insurance premiums, higher facility-based utility and maintenance costs, higher volume based processing costs, and increased expenses related to investments in the technology and facilities infrastructure.

· The Company's combined effective federal and state income tax rate increased 13.9 percentage points in 2008 to 19.0% primarily as a result of a smaller settlement of certain previously unrecognized tax positions as compared to the previous year.

Selected Profitability and Other Measures

Return on average assets, return on average equity, dividend payout and equity
to asset ratios for the years indicated are as follows:
                            Table 3: Selected Ratios

                                                 2008   2007   2006
               Return on average assets          0.97%  0.93%  0.90%
               Return on average equity          9.23%  9.20%  8.36%
               Dividend payout ratio             57.3%  57.1%  60.7%

As displayed in Table 3 above, the return on average assets increased in 2008 as compared to both 2007 and 2006. The increase in comparison to both years was a result of higher net income primarily due to solid organic growth and the 2008 and 2007 acquisitions. Reported return on equity in 2008 was also higher than 2007 and 2006's levels for similar reasons.

The dividend payout ratio for 2008 was above 2007's level due to dividends declared increasing 7.5%, versus the 7.1% growth in net income. The increase in dividends declared was the result of a 4.9% increase in the dividend paid per share as well as the additional 2.5 million shares issued during the common equity offering in the fourth quarter. The dividend payout ratio decreased in 2007 as compared to 2006 due to a larger increase in net income than the 5.0% increase in dividends declared.

Net Interest Income

Net interest income is the amount that interest and fees on earning assets (loans and investments) exceeds the cost of funds, which consists primarily of 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 disclosed in Table 4, net interest income (with nontaxable income converted to a fully tax-equivalent basis) totaled $163.6 million in 2008, up $12.8 million, or 8.5%, from the prior year. A $144 million increase in average interest-earning assets and an 18 basis point increase in net interest margin more than offset a $120 million increase in average interest-bearing liabilities. As reflected in Table 5, the higher net interest margin had a $7.5 million favorable impact, and the volume changes mentioned above increased net interest income by $5.3 million.

The net interest margin increased 18 basis points from 3.64% in 2007 to 3.82% in 2008. This increase was primarily attributable to a 52 basis point decrease in the cost of funds having a greater impact than the 34 basis point decrease in earning-asset yields. The decreased cost of funds was reflective of disciplined deposit pricing, in part due to the decreases in short-term market rates in 2008, as well as planned reductions of time deposit balances. Additionally, the rates on external borrowings decreased throughout the year, as a result of the refinancing of $150 million of Federal Home Loan Bank advances into lower cost instruments in the fourth quarter of 2007 and seven rate reductions by the Federal Reserve to the overnight federal funds rates since the end of 2007. The yield on loans decreased 44 basis points in 2008, again due in part to the declining interest rates throughout the market. The yield on investments decreased from 5.98% in 2007 to 5.81% in 2008 as cash flows from the maturing of higher yielding investments were used to fund loan growth rather than be reinvested at unfavorable market rates in the first half of the year, as well as the steep decline in yields earned on cash equivalents. In the second half of the year, the Company purchased investments in advance of the liquidity provided by the acquisition of the Citizens' branches in November 2008.

The net interest margin in 2007 was 3.64%, compared to 3.91% in 2006. This 27 basis point decline was primarily attributable to a 35 basis point increase in the cost of funds having a greater impact than the nine basis point increase in earning-asset yields. The increased cost of funds was due to rising rates on deposit products, primarily time deposits in the first three quarters of the year, as the rates on new volume were above those of maturing time deposits, in part due to increases in short-term market rates in 2005 and 2006. The rates on external borrowings decreased throughout the year, as a result of the early redemption of fixed rate trust preferred securities in the first quarter of 2007 and four rate reductions by the Federal Reserve to the overnight federal funds rates during the later half of 2007. The yield on loans increased 16 basis points in 2007. The yield on investments decreased from 6.04% in 2006 to 5.98% in 2007 due mostly to a leveraging strategy undertaken in mid-2007, as well as declines in short and medium term rates in the second half of the year.

As shown in Table 4, total interest income decreased by $5.1 million, or 1.9%, in 2008. Table 5 reveals that higher average earning assets contributed a positive $9.2 million variance offset by lower yields with a negative impact of $14.4 million. Average loans grew a total of $191.0 million in 2008, as a result of $41.6 million from the acquisitions of 18 Citizens branches in November 2008 and TLNB in June 2007 as well as $149.3 million of organic growth in all portfolios: business lending, consumer mortgage and consumer installment. Interest and fees were consistent with 2007, attributable to higher average loan balances offset by a 44 basis point decrease in loan yields. Total interest income increased by $24.5 million, or 9.9% in 2007 from 2006's level. Table 5 indicates that higher average earning assets contributed a positive $21.0 million variance and higher yields contributed $3.5 million. Average loans grew $229.6 million in 2007 over 2006, as a result of $186.5 million from the acquisitions of TLNB in June 2007, ONB in December 2006 and Elmira in August 2006 and $43.1 million of organic growth in the consumer mortgage and consumer installment portfolios. Interest and fees on loans increased $19.8 million, or 11.8%, in 2007 as compared to 2006. The increase was attributable to higher average loan balances, as well as a 16 basis point increase in loan yields due to increases in short-term rates in the first half of the year.

Investment interest income in 2008 of $78.5 million was $5.1 million, or 6.1%, lower than the prior year as a result of a smaller portfolio (negative $1.2 million impact), and a 17 basis point decrease in the investment yield. The decrease in balances was a result of cash flows from maturing investments being used to fund loan growth rather than be reinvested at unfavorable market rates. Investment purchases were initiated in the third and fourth quarters of 2008 in anticipation of the net liquidity that would be supplied by the Citizens' branch acquisition. Investment interest income in 2007 of $83.6 million was $4.7 million, or 5.9%, higher than the prior year as a result of a larger portfolio (positive $4.5 million impact). The performance of the investment portfolio in 2008 and 2007 remained strong despite the interest rate environment. During the third quarter of 2007, a $200 million short-term investment leverage strategy was initiated, which produced positive net interest income and served to demonstrate the company's ability to freely access liquidity sources despite tightened credit market conditions.

The average earning asset yield declined 34 basis points to 6.20% in 2008 because of the previously mentioned decreases in loan and investment yields. In 2008, the gap between loan and investment yields decreased to 58 basis points as the yield on the loan portfolio decreased 44 basis points while the yield on the investment portfolio decreased a smaller 17 basis points reflective of the loan portfolio having a significant proportion of variable and adjustable rate loans which declined as the interest rates decreased throughout 2008, whereas the investment portfolio was predominately comprised of fixed rate instruments. The average earning asset yield grew nine basis points to 6.54% in 2007 from 6.45% in 2006. During 2006, changes in market interest rates combined with the strategic investment portfolio actions previously discussed resulted in the yield on the loan portfolio being higher than the investment portfolio by 63 basis points. This gap widened in 2007 as the yield on the loan portfolio expanded and the investment portfolio yield stabilized resulting in loan yields being 85 basis points higher than the yield on the investment portfolio.

Total average funding (deposits and borrowings) in 2008 increased $134.4 million or 3.3%. Deposits increased $53.0 million, $102.8 million attributable to the acquisitions of the 18 Citizens branches and TLNB offset by a $49.8 million decrease in organic deposits. Consistent with the Company's funding mix objective, average core deposit balances increased $150.5 million, while time deposits were allowed to decline $97.5 million over the year. Average external borrowings increased $81.4 million in 2008 as compared to the prior year due primarily to the all-cash acquisitions of ABG, TLNB and HBT. However, year-end borrowings declined $66.8 million from the end of 2007 as a portion of the net liquidity from the branch acquisition was used to eliminate short-term . . .