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. Since the Fall of 2008, when there were historic disruptions in the American financial system, there has been a severe global recession.

Many economists believe that the recession in the United States, which has been described as the worst since the 1930's, has now ended. However, there is no agreement as to the speed of the economic recovery, and most economists believe that unemployment is likely to increase before beginning to decline. The Company was not negatively impacted during the initial phase of the recession. Its markets were not affected by the dramatic declines in real estate values seen in other areas of the country. In addition, the diverse economy in the Company's market area, including several large employers that are public educational institutions, have to date helped to insulate the Company's trade area from the worst effects of the recession. If the economic recovery is long and slow, unemployment may rise, resulting in a higher rate of delinquent loans and an increase in real estate foreclosures. Higher unemployment, as well as the fear of layoffs, also results in reduced consumer demand for goods and services, which negatively impacts the Company's business and professional customers. A slow economic recovery 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 these 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 our best estimate of the losses that may be sustained in our loan portfolio. The allowance is based on and calculated in compliance with two basic principles of accounting. The first principle requires that losses be accrued when they are probable of occurring and are estimable. The second accounting principle 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.
We strive to maintain the allowance for loan losses at a level, which in management's judgment, is sufficient to absorb the credit losses that are inherent in the loan portfolio.

Core Deposit Intangibles

Following generally accepted accounting principles, the Company annually utilizes an independent consulting firm to conduct an assessment of impairment of goodwill and core deposit intangibles. Additionally, acquired intangible assets (such as core deposit intangibles) are separately recognized if the benefit of the asset can be sold, transferred, licensed, rented, or exchanged and amortized over its estimated useful life. Any intangible asset arising from a branch acquisition transaction is subject to amortization over its estimated useful life.
The Company evaluated 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, in light of changes in generally accepted accounting principles which became effective at that time and which remain in effect. These changes required a different accounting treatment of intangible assets that are a part of a transaction in which a separate business enterprise is acquired. The Company determined that those acquisitions did not constitute the acquisition of a business and therefore continues to amortize the intangible assets.

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 nine months ended
September 30, 2009 and year ended December 31, 2008.
                                               September 30,      December 31,
                                                   2009               2008
       Return on average assets                          1.45 %            1.51 %
       Return on average equity                         12.20 %           12.52 %
       Net interest margin (1)                           4.13 %            4.12 %
       Noninterest margin (2)                            1.55 %            1.46 %
       Basic net earnings per share           $          1.52     $        1.96
       Fully diluted net earnings per share   $          1.52     $        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 nine months ended September 30, 2009 was 1.45%, a decline of 6 basis points from 1.51% for the year ended December 31, 2008. The decline is the result of internally generated asset growth increasing at a faster rate than earnings. The return on average equity declined from 12.52% for the year ended December 31, 2008 to 12.20% for the nine months ended September 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 nine months in 2009. The total of FDIC premiums for the three quarters of 2009 was $1,429, as compared with $90 for the same period of 2008. In the third quarter of 2009, the total of FDIC premiums was $423, as compared with $47 in the third quarter of 2008. The net interest margin, at a healthy 4.13%, was 1 basis point higher than the 4.12% at year-end.
Although the net interest margin of 4.13% at September 30, 2009 remained healthy and underlying earnings were strong, the Company's earnings for the third quarter of 2009 continued to be negatively affected by a significant increase in Federal Deposit Insurance Corporation Deposit Insurance Fund premiums. A special assessment which was accounted for in the second quarter of 2009 and payable on September 30, 2009, was imposed to increase the Deposit Insurance Fund's reserve ratio, which has been impacted by an increased number of bank failures. Earlier in 2009 the FDIC proposed imposing an additional special assessment or assessments in late 2009 or early 2010. However, on September 29, 2009, the Board of Directors of the Federal Deposit Insurance Corporation proposed an alternative strategy to strengthen the Deposit Insurance Fund. The FDIC promulgated a rule that would require institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The rule is not yet final, but, if adopted, the Company has sufficient liquidity to make the required payments without a material impact on its business.

Growth

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

                      September 30, 2009       December 31, 2008     Percent Change
      Securities     $            302,243     $           264,999          14.05 %
      Loans, net                  575,188                 569,699           0.96 %
      Deposits                    835,873                 817,848           2.20 %
      Total assets                965,888                 935,374           3.26 %

Securities, deposits and total assets all grew in the first nine 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. The low interest rate environment also limited the attractiveness of alternative investment vehicles.

Asset Quality

Key asset quality indicators are shown below:

                                          September 30, 2009      December 31, 2008
    Nonperforming loans                  $           3,888       $           1,333
    Loans past due 90 days or more                   2,153                   1,127
    Other real estate owned                          1,944                   1,984
    Allowance for loan losses to loans                1.11 %                  1.02 %
    Net charge-off ratio                              0.08 %                  0.09 %

Nonperforming loans at September 30, 2009, all of which were nonaccrual loans, were $3,888, or 0.67% of loans net of unearned income and deferred fees, plus other real estate owned. Nonperforming loans increased by $2,555 over the $1,333 reported on December 31, 2008. Loans past due 90 days or more at the end of the third quarter of 2009 were $2,153, up $1,026 from the total at year-end and were 0.37% of loans net of unearned income at September 30, 2009. Although the totals of nonperforming loans and loans past due 90 days or more have grown when compared with year-end, the ratios of both to total loans remained low when compared with peers and are consistent with the Company's conservative underwriting policies. The Company anticipates further increases in nonperforming and past due loans as its market area is impacted by the effects of the slow economy. Exposure to loss is somewhat mitigated because a significant percentage of loans are collateralized with real estate. The Company has dedicated sufficient resources to monitoring the quality of the loan portfolio and to working out problem assets. Management is monitoring changes and indicators of risk in the loan portfolio. Throughout 2009, the Company has steadily increased the allowance for loan losses to account for the increase in nonperforming loans and the higher 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 1.11% at September 30, 2009. The net charge-off ratio, at 0.08% on September 30, 2009 declined by 1 basis point from the prior year-end. Additional information about the factors used in calculating the allowance for loan losses is presented in Note (3) "Allowance for Loan Losses Nonperforming Assets and Impaired Loans".

Net Interest Income

Net interest income for the nine months of 2009 was $25,343, an increase of $2,168, or 9.4%, when compared with the same period in 2008. This net increase is attributable to a decrease of $1,855 in interest expense and an increase in interest income of $313. As compared with the first nine months of 2008, the lower interest rate environment in the first three quarters of 2009 caused the Company's yield on earning assets to decline. However, a higher volume of earning assets resulted in the $2,168 increase in total interest income for the nine months ended September 30, 2009. Despite an increase in total deposits when September 30, 2009 and September 30, 2008 are compared, as noted above, total interest expense dropped by $1,855. This decline is attributable to a combination of lower interest rates and the Company's prudent 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 have been called and been replaced with securities yielding a 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. When interest rates eventually rise, the net interest margin will narrow, because deposit rates will increase at a faster rate than loan rates. If interest rates rise slowly, the negative effect on the net interest margin would be less pronounced.

The provision for loan losses for the nine-month period ended September 30, 2009 was $953. The ratio of the allowance for loan losses to total loans at the end of the third quarter of 2009 was 1.11%, which compares to 1.02% at December 31, 2008. The net charge-off ratio was 0.08% at September 30, 2009 and 0.09% at December 31, 2008.
During the third quarter of 2009, management added to the provision for loan losses in an amount it believes is prudent, given current economic conditions. Refer to the "Critical Accounting Policies" section of this report for more information related to the methodology used to establish the Allowance for Loan Losses. At September 30, 2009, the total of impaired loans was $5,812. The majority of the impaired loans have unliquidated collateral associated with them. The specific allowance for loan losses attributable to impaired loans was $1,718 at the end of the third quarter. 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

                                                           Nine Months ended
                                                     September 30,      September
                                                         2009            30, 2008      Percent Change
Service charges on deposit accounts                  $       2,506     $      2,502          0.16    %
Other service charges and fees                                 263              250          5.20    %
Credit card fees                                             2,060            2,101         (1.95 )  %
Trust fees                                                     792              929        (14.75 )  %
Bank-owned life insurance income                               554              446         24.22    %
Other income                                                   261              314        (16.88 )  %
Realized securities gains                                       55              189        (70.90 )  %

Service charges on deposit accounts totaled $2,506 for the nine months ended September 30, 2009. This is a small increase of $4, or 0.16%, when compared with 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.
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 $263 for the nine months ended September 30, 2009, up by 5.20% from $250 for the nine months ended September 30, 2008. Credit card fees for the first nine months of 2009 were $2,060. This was a decrease of $41, or 1.95%, when compared with the $2,101 total reported for the same period last year. The decline was due to a lower volume of merchant transaction fees and credit card fees.
Trust fees, at $792, were down by $137, or 14.75%, from the $929 earned in the third 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 declined significantly during 2008 and early 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 $108, or 24.22%, to $554 for the nine months ended September 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 nine months ended September 30, 2009 was $261. This represents a decrease of $53, or 16.88%, when compared with the nine months ended September 30, 2008. There was a $13 gain from the sale of repossessed automobiles in the first nine months of 2008 that was not repeated in the same period in 2009, and income from commissions for the sale of securities in NBFS has declined by $27 when the two periods are compared.
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 nine months ended September 30, 2008. Realized securities gains for the nine months ended September 30, 2009 were $55, as compared with $189 for the same period in 2008. Realized securities gains in 2009 have come solely from gains in called securities.

Noninterest Expense

                                                           Nine Months ended
                                                     September 30,      September
                                                         2009            30, 2008      Percent Change
Salaries and employee benefits                       $       8,409     $      8,395           0.17   %
Occupancy, furniture and fixtures                            1,344            1,328           1.20   %
Data processing and ATM                                      1,016            1,033          (1.65 ) %
FDIC insurance                                               1,429               90       1,478.78   %
Credit card processing                                       1,551            1,570          (1.21 ) %
Intangibles amortization                                       822              841          (2.26 ) %
Net costs of other real estate owned                           100               64          56.25   %
Franchise taxes                                                666              619           7.59   %
Other operating expenses                                     2,364            2,354           0.42   %

Salary and benefits expense increased only $14, or 0.17%, from $8,395 for the nine months ended September 30, 2008 to $8,409 for the nine months ended September 30, 2009. The Company has made an effort to control salary costs. Occupancy, furniture and fixtures expense was $1,344 for the nine months ended September 30, 2009, an increase of $16, or 1.20%, 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.
Data processing and ATM expense was $1,016 for the first nine months ended September 30, 2009, a decrease of $17, or 1.65%, from the nine months ended September 30, 2008. During the first three quarters of 2008, the Company had higher data processing costs associated with branch capture and merchant capture projects.
As previously discussed, when September 30, 2008 and September 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 nine months last year was $90. This compares with $1,429 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.
Credit card processing expense was $1,551 for the nine months ended September 30, 2009, a decrease of $19, or 1.21%, from the total for the nine months ended September 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 2.26% decline, from $841 for the nine months ended September 30, 2008 to $822 for the nine months ended September 30, 2009.
Net costs of other real estate owned have increased from $64 for the nine months . . .