Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with GAAP and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates,

assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available.

Significant accounting policies followed by the Company are presented in Note 1 to the Company's 2011 consolidated financial statements which can be found in the Company's Form 10-K and recent accounting provisions adopted have been presented herein in Note I. These policies, along with the disclosures presented in the other financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts management has identified the determination of the allowance for credit losses to be the accounting area that requires the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.

The allowance for credit losses represents management's estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for credit losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet.

Allowance for Credit Losses Methodology

The Bank's allowance for credit losses is established through a provision for loan losses based on management's evaluation of the risks inherent in its loan portfolio and the general economy. The allowance for credit losses is maintained at an amount management considers adequate to cover estimated losses in loans receivable which are deemed probable and estimable based on information currently known to management. The overall allowance consists of both ASC 310 specific reserves for individual loans and ASC 450 general reserves for loan portfolios by specific categories and types. The Bank estimates an acceptable allowance for credit loss with the objective of quantifying portfolio risk into a dollar figure of inherent losses, thereby translating the subjective risk value into an objective number. Emphasis is placed on independent external loan reviews and regular internal reviews. The determination of the allowance for loan losses is based on the Bank's historical loss experience and ten
(10) qualitative factors for specific categories and types of loans. The combination of the loss experience factor and the total qualitative factors ("Total

ALLL Factor") is expressed as a percentage of the portfolio for specific categories and types of loans to create the inherent loss index for each loan portfolio. Individual loans deemed impaired are separated from the respective loan portfolios and a specific reserve allocation is assigned based upon Bank management's best estimate as to the loss exposure for each loan. Each Total ALLL Factor is assigned a percentage weight and that total weight is applied to each loan category. The Total ALLL Factor is different for each loan type and for each risk assessment category within each loan type.

• The Bank's historical loss experience is calculated by aggregating the actual loan losses by category for the previous eight quarters and converting that total into a percentage for each loan category.

Previously (in 2011), due to the Bank's limited historical loss experience, the loss experience factor was the greater of either the Bank's historical loss experience or the peer group average historical loss experience.

• Qualitative factors include: levels and trends in delinquencies and non-accruals; trends in volumes and terms of loans; effects of any changes in lending policies; the experience, ability and depth of management; national and local economic trends and conditions (including Peer Group loss experience); concentrations of credit; quality of the bank's loan review system; and, external factors, such as competition, legal and regulatory requirements.

The total allowance for credit losses changes as the percentage weight assigned to each Total ALLL Factor is increased or decreased due to its particular circumstance, as the various types and categories of loans change as a percentage of total loans and as the aggregate of specific allowances is adjusted due to an increase or decrease in impaired loans.

Management believes this approach effectively measures the risk associated with any particular loan or group of loans. The Bank's Board of Directors engages an independent loan review consultant to evaluate the adequacy of the Bank's allowance for credit losses. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for credit losses. Such agencies may require the Bank to make additional provisions for estimated credit losses based upon judgments different from those of management. The Bank recorded a total provision for credit losses of $167,000 for the three month period ended March 31, 2012 and $557,000 for the same period in 2011. The aggregate provision was based upon the results of quarterly evaluations using a combination of factors including the level of nonperforming loans, the Bank's growth in total gross loans and the Bank's net credit loss experience. Total gross loans, increased by $10.4 million for the three months ended March 31, 2012. For the same period, the Bank recorded charge-offs of $603,000 and recovered $19,000 on previously charged-off loans. As of March 31, 2012, the Bank's allowance for credit losses was $6.8 million or 2.25% of total loans and 97.94% of nonperforming loans as compared to $7.2 million, or 2.47% of total loans and 102.3% of nonperforming loans as of December 31, 2011.

The Bank continues to monitor and modify its allowance for credit losses as conditions dictate. While management believes that, based on information currently available, the Bank's allowance for credit losses is sufficient to cover losses inherent in its loan portfolio at this time, no assurances can be given that the Bank's level of allowance for credit losses will be sufficient to cover future loan losses incurred by the Bank or that future

adjustments to the allowance for credit losses will not be necessary if economic and other conditions differ substantially from economic and other conditions at the time management determined the current level of the allowance for credit losses. Management may in the future increase the level of the allowance as its loan portfolio increases or as circumstances dictate.

Activity in the allowance for credit losses for the three months ended March 31, 2012 and 2011 is shown below:

                                                                   For the Three Months
(dollars in thousands)                                               Ended March 31,
                                                                  2012              2011
Total loans outstanding - at March 31,                         $  300,863         $ 285,072
Average loans outstanding year-to-date                            296,497           282,037
Allowance for credit losses at beginning of period             $    7,182         $   6,853

Provision charged to expense                                          167               557

Chargeoffs:
Commercial loans                                                       32               471
Real estate and construction loans                                    340                 0
Consumer and other loans                                              231                55

Total                                                                 603               526

Recoveries:
Commercial loans                                                        9                 5
Real estate and construction loans                                      2                 0
Consumer and other loans                                                8                 3

Total                                                                  19                 8

Net chargeoffs                                                        584               518

Allowance for credit losses at end of period                   $    6,765         $   6,892

Allowance for credit losses as a percent of total loans              2.25 %            2.42 %
Net chargeoffs (recoveries) as a percent of average loans            0.20 %            0.18 %

The Bank's nonperforming assets, which are comprised of loans delinquent 90 days or more, non-accrual loans, loans that are categorized as being a troubled debt restructuring, loans with repossessed collateral and repossessed assets totaled $8.5 million at March 31, 2012, compared to $8.3 million at December 31, 2011, an increase in nonperforming assets of $221,000 or 2.7% The percentage of nonperforming assets to total assets was 1.94% at March 31, 2012, compared to 1.88% at December 31, 2011. The increase in nonperforming assets was principally attributable to the addition of a $671,000 in nonaccrual loans and a $234,000 matured loan under consideration for renewal past due more than 90 days and still accruing. Offsetting the additions to nonperforming were charge-offs of $452,000 and payments and payoffs totaling $232,000.

The $8.5 million in nonperforming assets at March 31, 2012 included $5.8 million in nonaccrual loans, $234,000 in loans past due more than 90 days, $854,000 in accruing troubled debt restructuring and $1.6 million in other assets. Of the $5.8 million in nonaccrual loans at March 31, 2012, $5.2 million were secured by real estate, $414,000 were commercial loans and $156,000 were consumer and other loans. At December 31, 2011, assets classified as nonperforming totaled $8.3 million and consisted of $6.2 million in nonaccrual loans and $856,000 in accruing troubled debt restructuring and $1.3 million in other assets. Included in the $6.2 million of nonaccrual loans was $5.3 million of loans secured by real estate, $390,000 of commercial and $484,000 of consumer and other loans.

Comparison of Financial Condition at March 31, 2012 and December 31, 2011

Total assets of $440.6 million at March 31, 2012 decreased 0.23% or $1.0 million compared to $441.6 million at December 31, 2011. Loan demand improved in the first three months of 2012, with $301.2 million of gross loans as of March 31, 2012, an increase of $10.4 million from $290.8 million at December 31, 2011. The increase resulted primarily from the origination, net of payments of approximately $9.6 million in real estate secured loans and $1.4 million in commercial loans offset by charge-offs of $603,000. Interest bearing balances with banks increased $19.0 million as cash previously maintained in federal funds sold was transferred to other interest bearing balances with banks. Investment securities decreased $4.8 million or 5.4% to $82.8 million from $87.5 million at December 31, 2011 balance.

Deposits of $346.7 million at March 31, 2012 decreased $3.7 million or 1.1% from December 31, 2011 deposits of $350.4 million. Money market balances increased $3.0 million in total while demand deposit balances decreased $1.7 million. The primary increase in money market balances was due to a related party transaction whereby funds were deposited to purchase and payoff $2.5 million of notes relating to loans outstanding to one borrower. Certificate of deposit balances decreased $5.4 million. Certificates totaling $3.0 million invested in the CDARS program matured and were not renewed.

Comparison of Operating Results for the Three Months Ended March 31, 2012 and 2011.

General. The Company recorded net income of $824,000 for the three months ended March 31, 2012; an increase of $315,000, compared to net income of $509,000 for the three months ended March 31, 2011. Net income available to common shareholders for the three months ended March 31, 2012 was $716,000 or $0.18 per basic and diluted common shares compared to net income available to common shareholders of $387,000 or $0.10 per basic and diluted shares for the three months ended March 31, 2011. Net interest income increased by $56,000 or 1.4% for the three months ended March 31, 2012 compared to the same period in 2011. The provision for credit losses decreased $390,000 to $167,000 for the three months ended March 31, 2012 compared to $557,000 for the three month period ended March 31, 2011.

Interest Income. Total interest and dividend income decreased $102,000 or 2.1% for the three months ended March 31, 2012 compared to the same period in 2011 as a result of lower yields on investments. Interest income on investments decreased $151,000. The yield on the investment securities portfolio decreased to 2.57% from 3.01% on balances $8.0 million lower on average over the same period in 2011. Income on the loan portfolio increased $41,000 or 1.0% for the three months ended March 31, 2012. The improvement in interest income on the loan portfolio was due to an increase in average loan balances of $14.5 million. Income of approximately $180,000 on a loan previously categorized as nonaccrual was recognized during the three month period ended March 31, 2011. The yield on the loan portfolio decreased to 5.74% for the three months ended March 31, 2012 from 6.03% for the three months ended March 31, 2011.

Interest Expense. Total interest expense decreased by $158,000 or 17.0% for the three months ended March 31, 2012 compared to the three months ended March 31, 2011. The decrease was due to reducing the yields on the Company's deposit products including the Company's "Superior Savings" account. The Company's savings accounts had an average balance of $134.5 million for the three months ended March 31, 2012 and a yield of 0.36% compared to an average balance of $139.7 million and a yield of 0.73% for the three months ended March 31, 2011. Contributing to the decrease in interest expense were lower yields on all other deposit products, primarily money market accounts and certificates of deposit and lower yields on repurchase agreements. The average rate of interest paid on all interest bearing liabilities was 0.90% for the three months ended March 31, 2012 compared to 1.09% for the three months ended March 31, 2011. Interest expense on long-term borrowings and junior subordinated debentures was $328,000 for the three months ended March 31, 2012 compared to $321,000 for the three months ended March 31, 2011, an increase of $7,000.

Net Interest Income. Net interest income increased by $56,000 or 1.4% for the three months ended March 31, 2012 compared to the three months ended March 31, 2011. The increase was primarily the result of the lower overall cost of deposits. The Company's cost of funds decreased to 0.78% for the three months ended March 31, 2012 compared to 0.97% for the three months ended March 31, 2011.

For the three months ended March 31, 2012, the net interest margin decreased to 3.87% compared to 4.00% for the three months ended March 31, 2011. The decrease in net interest margin was primarily the result of the decrease in the yield on new loans and investments. The yield on earning assets decreased to 4.61% for the three months ended March 31, 2012 from 4.93% for the same period in 2011.

Provision for Credit Losses. The Bank recorded a provision for credit losses of $167,000 for the three months ended March 31, 2012 compared to $557,000 for the same period in 2011. The provision was based on the composition and credit quality of the loan portfolio as of March 31, 2012 and reflected the qualitative factors used to calculate the allowance for credit losses relating to historical delinquencies and losses and to factors relating to local economic conditions. Total gross loans increased by $10.4 million for the three month period ended March 31, 2012 compared to December 31, 2011. The Bank recorded net charge-offs on loans deemed uncollectible of $584,000 for the three months ended March 31, 2012 compared to $518,000 for the same period in 2011.

Noninterest Income. Total noninterest income increased by $69,000 or 18.8% to $437,000 for the three months ended March 31, 2012. Noninterest income was $368,000 for the same period in 2011. The increase in noninterest income was due to higher mortgage banking fees of $44,000 and gains on the sale of repossessed assets of $20,000 compared to a loss of $31,000 on the disposal of fixed assets recorded for the three months ended March 31, 2011.

Noninterest Expense. Total noninterest expense decreased by $49,000 or 1.6% for the three months ended March 31, 2012 compared to the same period in 2011. The decrease in total noninterest expense during the first three months of 2012 compared with the same period in 2011 was the result of lower personnel expense, lower occupancy and equipment expense and lower FDIC expense offset by higher legal expenses. Personnel expense decreased $72,000 over the same period in 2011 due to open staff positions and to the reversal of expense resulting from the forfeiture of stock grants. Occupancy and equipment expense decreased $43,000 compared to the three months ended March 31, 2011 as 2011 expense included accelerated depreciation on assets from the Bank's Market House branch

that was closed in 2011. FDIC insurance expense decreased $64,000 compared to the same period in the prior year as a result of the FDIC's revised assessment methodology. An increase in legal expense of $50,000 was the result of increased collection costs in 2012 as the first quarter of 2011 included recoupment of $44,000 of legal expenses from the payoff of a nonaccrual loan.

Income Tax Expense. The Company recorded income tax expense for the three-month period ended March 31, 2012 of $486,000 compared to $237,000 for the three months ended March 31, 2011. The Company's combined effective federal and state income tax rate was approximately 37.1% for the three months ended March 31, 2012 versus 35.8% for the three months ended March 31, 2011.

The table below sets forth certain information regarding changes in interest income and interest expense attributable to (1) changes in volume (change in volume multiplied by the old rate); (2) changes in rates (change in rate multiplied by the old volume); and (3) changes in rate/volume (change in rate multiplied by change in volume).

Rate/Volume Analysis



(dollars in thousands)                                 Three Months Ended March 31, 2012 vs. 2011
                                                                                Due to Change in
                                            Increase or                                                 Rate/
                                            (Decrease)             Volume              Rate            Volume
Interest income on:
Loans                                      $          41          $    217                ($212 )      $    36
Investment securities                               (151 )             (60 )               (108 )           17
Interest bearing deposits in other
banks                                                  3                 0                    3              0
Federal funds sold and other overnight
Investments                                            5                 5                    0              0

Total interest income                               (102 )             162                 (317 )           53
Interest expense on:
NOW accounts                                          (3 )               0                   (3 )            0
Money market accounts                                (12 )              13                  (20 )           (5 )
Savings accounts                                    (128 )              (9 )               (126 )            7
Certificates of deposit                              (16 )             (15 )                 (4 )            3
Repurchase agreements                                 (6 )              (1 )                 (5 )           (0 )
Long-term borrowing                                    3                 0                    0              3
Junior subordinated debt                               4                 0                    4              0

Total interest expense                              (158 )             (12 )               (154 )            8

Net interest income                        $          56          $    174                ($163 )      $    45

Consolidated Average Balances, Yields and Rates

(dollars in thousands)



                                                                 Three Month Periods Ended
                                                 March 31, 2012                             March 31, 2011
                                       Average       Interest       Yield/        Average       Interest       Yield/
                                       Balance         (1)           Rate         Balance         (1)           Rate
Assets
Interest earning assets
Federal funds sold and other
overnight investments                 $  20,449     $       12         0.24 %    $  11,870     $        7         0.24 %
Interest bearing balances with
banks                                    15,478              7         0.18 %       14,482              4         0.11 %
Investment securities (1)                87,303            557         2.57 %       95,278            708         3.01 %
Loans (2)                               296,497          4,232         5.74 %      282,037          4,191         6.03 %

Total interest earning assets           419,727          4,808         4.61 %      403,667          4,910         4.93 %
Noninterest earning assets
Cash and due from banks                   7,362                                      7,874
Other assets                             13,836                                     15,744

Total Assets                          $ 440,925                                  $ 427,285

Liabilities and Stockholders'
Equity
Interest bearing deposits
NOW accounts                          $  31,872     $        8         0.10 %    $  32,811     $       11         0.14 %
Money market accounts                    51,887             39         0.30 %       41,568             51         0.50 %
Savings accounts                        134,536            122         0.36 %      139,661            250         0.73 %
Certificates of deposit                  73,816            266         1.45 %       77,879            282         1.47 %
Repurchase agreements                    12,425             11         0.36 %       13,559             17         0.51 %
Long-term borrowings                     35,000            281         3.23 %       35,000            278         3.22 %
Junior subordinated debt                  5,000             47         3.78 %        5,000             43         3.49 %

Total interest bearing liabilities      344,536            774         0.90 %      345,478            932         1.09 %

Noninterest bearing Liabilities
Demand deposit accounts                  56,044                                     44,974
Other liabilities                         2,534                                      1,945
Stockholders' Equity                     37,811                                     34,888

Total Liabilities and Stockholders'
Equity                                $ 440,925                                  $ 427,285

Interest rate spread                                                   3.70 %                                     3.84 %
Ratio of interest earning assets to
interest bearing liabilities                                         121.82 %                                   116.84 %
Net interest income and net
interest margin                                     $    4,034         3.87 %                  $    3,978         4.00 %

(1) No tax-equivalent adjustments are made, as the effect would not be material.

(2) Includes nonaccrual loans

Liquidity

Liquidity is the capacity to change the nominal level and mix of assets or liabilities, for any purpose, quickly and economically. Poor or inadequate liquidity risk management could result in a critical situation in which the Bank would be unable to meet deposit withdrawal or loan funding requests from its customers. Either situation could potentially harm both the profits and reputation of the Bank.

The Company's major source of liquidity is its deposit base. At March 31, 2012, total deposits were $346.7 million. Core deposits, considered to be stable funding sources and defined as all deposits except time deposits totaled $273.7 million or 79.0% of total deposits. Liquidity is also provided through the Company's overnight investment in federal funds sold, interest bearing deposits with banks as well as securities available-for-sale and investment securities with maturities less than one year. At March 31, 2012, interest bearing deposits with banks, federal funds sold and other overnight investments totaled $37.3 million while investment securities available-for-sale totaled $82.8 million.

In addition, the Bank has external sources of funds, which can be used as needed. The FHLB is the primary source of this external liquidity. The FHLB has established credit availability for banks up to 40% of the bank's total assets. The Bank currently has an approved line of credit with the FHLB of 25% of total . . .