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 nine months ended September 30, 2009 and 2008, although in some circumstances the second 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, "third quarter" refers to the quarter ended September 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 38.

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. 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.

Third quarter and September year-to-date 2009 net income of $12.5 million and $32.1 million, respectively, was $0.7 million or 5.7% higher and $1.9 million or 5.6% lower than the respective prior year periods. Earnings per share were $0.38 and $0.97 for the three and nine months ended September 30, 2009, respectively, a decrease of $0.01 and $0.15, from the equivalent prior year periods. Higher operating expenses, principally from acquisitions completed in 2008, significantly higher FDIC insurance assessments, 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. Third quarter and year-to-date 2009 results included the incurrence of an additional $1.0 million and $6.0 million, respectively, of FDIC-insurance related assessments, or $0.02 and $0.14 per share, respectively, above the three and nine month periods of 2008. Excluding these additional assessments, earnings per share for the quarter were $0.01 higher than the reported results from last year's third quarter.

Asset quality in the third quarter of 2009 remained stable, and favorable as compared to peer financial organizations. Loan charge-offs declined from both the third quarter of 2008, as well as the previous quarters of 2009. Nonperforming loan and delinquency ratios and the provision for loan losses were up versus the third quarter of 2008, but they continue to be below 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 third quarter of 2008 and June 30, 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 third quarter of 2009 as compared to both the second quarter of 2009 and the third quarter of 2008, reflective of the Citizens acquisition and organic growth in core deposits. External borrowings decreased from the third quarter of 2008 and remained consistent with the second quarter of 2009.

Net Income and Profitability

As shown in Table 1, net income for the third quarter of $12.5 million increased $0.7 million or 5.7% versus the third quarter of 2008. September year-to-date net income of $32.1 million declined $1.9 million or 5.6% as compared to the first nine months of 2008. Earnings per share for the third quarter and September year-to-date periods of $0.38 and $0.97, respectively, declined 2.6% and 13.4% versus the comparable periods of 2008. As compared to the second quarter of 2009, net income increased $3.3 million or 36% and earnings per share increased $0.10 or 36%.

Third quarter net interest income of $41.9 million was up $4.8 million or 13% from the comparable prior year period and net interest income for the first nine months of 2009 increased $14.4 million or 13% over the first nine months of 2008. The current quarter's provision for loan losses increased $0.4 million as compared to the third quarter of 2008 and increased $2.9 million for the first nine months of 2009 as compared to the same period of 2008, reflective of a continued higher level of net charge-offs and the general deteriorating economic conditions. Third quarter noninterest income, excluding securities gains and losses, was $20.8 million, up $1.4 million or 7.3% from the third quarter of 2008, while year-to-date noninterest income of $61.8 million increased $7.4 million or 14% from the prior year level. Operating expenses of $44.1 million for the quarter and $136.0 million for the first nine months of 2009 were up $4.9 million or 12% and $21.4 million or 19%, 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 of 2009, as well as an increase in pension costs.

As reflected in Table 1, the primary reasons for higher earnings in the quarter were higher noninterest income and net interest income partially offset by higher operating expenses and loan loss provision. Earnings per share declined slightly due to the higher number of shares outstanding which was mostly driven by the equity offering in the fourth quarter of 2008. For the nine months ended September 30, 2009, the primary reason for lower earnings were higher operating expenses and loan loss provision, partially offset by higher net interest income and noninterest income. Net interest income for the third 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 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 generally unfavorable economic trends 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    Nine Months Ended
                                     September 30,        September 30,
           (000's omitted,
           except per share
           data)                    2009      2008        2009      2008
           Net interest income      $41,852   $37,073    $122,552 $108,111
           Provision for loan
           losses                     2,375     1,985       7,200    4,335
           Noninterest income
           excluding security
           gains/losses              20,806    19,383      61,811   54,420
           Gain on sales of
           investment
           securities                     7         0           7      230
           Operating expenses        44,111    39,256     135,995  114,585
           Income before taxes       16,179    15,215      41,175   43,841
           Income taxes               3,724     3,429       9,100    9,870
           Net income               $12,455   $11,786     $32,075  $33,971

           Diluted earnings per
           share                      $0.38     $0.39       $0.97    $1.12

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 third quarter of 2009 was $45.8 million, a $5.1 million increase from the same period last year. A $554 million increase in third quarter interest-earning assets versus the prior year had a greater impact than the $438 million increase in average interest-bearing liabilities and a four-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 $15.5 million favorable impact on net interest income, while the volume increase from interest bearing liabilities and rate decrease on interest bearing assets had a $10.4 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. September YTD net interest income of $134.4 million increased $15.0 million or 13% from the year-earlier period. A $560 million increase in interest bearing assets more than offset a $462 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 $47.5 million favorable impact that was partially offset by a $32.5 million unfavorable impact from the decrease in the rate on interest bearing assets and the increase in interest-bearing liability balances.

Higher third quarter and September year-to-date average loan balances were attributable to $111 million of loans acquired in the Citizens acquisition and organic growth in the business lending and consumer installment portfolios. As compared to the second quarter of 2009, average loans declined $22.8 million primarily from continued principal amortization in the Company's consumer mortgage and home equity portfolios, combined with its decision to sell the majority of its longer-term, lower rate mortgage originations in the quarter and year-to-date periods. Average investments and cash equivalents for the third quarter and YTD periods were $435 million and $336 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 $624 million or 19% for the quarter primarily as a result of the November 2008 acquisition of Citizens, which included $565 million of deposits at the date of acquisition. On an organic basis, average interest bearing deposits for the third quarter increased $59 million from the third quarter of 2008. Organic growth in average noninterest bearing deposits was $47 million over the third quarter of 2008. Quarterly average borrowings decreased $67.9 million as compared to the third 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 3.78% for both the third quarter and year-to-date periods decreased four basis points and two basis points, respectively, versus the same periods in the prior year. The decline was primarily attributable to a 69-basis point decrease in the earning asset yield for both the quarter and year-to-date periods, as compared to the prior year periods. The decrease in the earning asset yield is due to a 123-basis point and 108-basis point decline in the investment yields for the third quarter and YTD periods, respectively and a 35-basis point and 46-basis point decline in the loan yields for the third quarter and YTD periods, respectively, as compared to the like periods of 2008. The change in the earning-asset yield is primarily a result of variable and adjustable-rate loans repricing downward and lower rates on fixed rate new loan volume due to the decline in interest rates to levels below those prevalent in prior years, 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 68-basis point and a 69-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 third quarter cost of funds decreased 68 basis points versus the prior year quarter due to a 88-basis point decrease in interest-bearing deposit rates and a seven-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 nine months of 2009 in response to market conditions. Additionally, the proportion of customer deposits in higher cost time deposits has declined 7.0 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 230 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 set 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
                               September 30, 2009               September 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          $292,545     $200      0.27%       $4,320      $24      2.18%
 Taxable investment
securities (1)              864,478    9,914      4.55%      766,582    9,811      5.09%
 Nontaxable investment
securities (1)              560,615    9,532      6.75%      511,299    8,758      6.81%
 Loans (net of unearned
discount)                 3,082,495   46,183      5.94%    2,963,504   46,866      6.29%
   Total
interest-earning assets   4,800,133   65,829      5.44%    4,245,705   65,459      6.13%
Noninterest-earning
assets                      549,629                          466,718
   Total assets          $5,349,762                       $4,712,423

Interest-bearing
liabilities:
 Interest checking,
savings and money market
deposits                 $1,873,536    2,702      0.57%   $1,348,288    2,691      0.79%
 Time deposits            1,290,860    7,910      2.43%    1,310,393   12,070      3.66%
 Short-term borrowings      593,385    6,415      4.29%      477,139    4,644      3.87%
 Long-term borrowings       265,120    3,009      4.50%      449,292    5,336      4.72%
   Total
interest-bearing
liabilities               4,022,901   20,036      1.98%    3,585,112   24,741      2.75%
Noninterest-bearing
liabilities:
 Demand deposits            708,430                          590,098
 Other liabilities           58,669                           49,964
Shareholders' equity        559,762                          487,249
   Total liabilities and
shareholders' equity     $5,349,762                       $4,712,423

Net interest earnings                $45,793                          $40,718
Net interest spread                               3.46%                            3.38%
Net interest margin on
interest-earnings assets                          3.78%                            3.82%

Fully tax-equivalent
adjustment                            $3,941                           $3,645

(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

                               Nine Months Ended                Nine Months Ended
                               September 30, 2009               September 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          $254,935     $499      0.26%      $25,983     $482      2.48%
 Taxable investment
securities (1)              833,708   30,445      4.88%      760,567   30,303      5.32%
 Nontaxable investment
securities (1)              559,417   28,489      6.81%      525,530   27,154      6.90%
 Loans (net of unearned
discount)                 3,109,210  139,340      5.99%    2,885,267  139,375      6.45%
   Total
interest-earning assets   4,757,270  198,773      5.59%    4,197,347  197,314      6.28%
Noninterest-earning
assets                      542,579                          467,623
   Total assets          $5,299,849                       $4,664,970

Interest-bearing
liabilities:
 Interest checking,
savings and money market
deposits                 $1,789,844    8,616      0.64%   $1,304,616    7,926      0.81%
 Time deposits            1,367,146   27,653      2.70%    1,356,937   40,569      3.99%
 Short-term borrowings      555,126   17,691      4.26%      441,347   13,321      4.03%
 Long-term borrowings       304,608   10,430      4.58%      451,971   16,108      4.76%
   Total
interest-bearing
liabilities               4,016,724   64,390      2.14%    3,554,871   77,924      2.93%
Noninterest-bearing
liabilities:
 Demand deposits            677,323                          569,764
 Other liabilities           53,753                           53,851
Shareholders' equity        552,049                          486,484
   Total liabilities and
shareholders' equity     $5,299,849                       $4,664,970

Net interest earnings               $134,383                         $119,390
Net interest spread                               3.45%                            3.35%
Net interest margin on
interest-earnings assets                          3.78%                            3.80%

Fully tax-equivalent
adjustment                           $11,831                          $11,279

(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.

. . .