Introduction

This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") primarily reviews the financial condition and results of operations of Community Bank System, Inc. (the "Company" or "CBSI") as of and for the three and six months ended June 30, 2012 and 2011, although in some circumstances the first quarter of 2012 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 24. 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 2012, "second quarter" refers to the quarter ended June 30, 2012, and earnings per share ("EPS") figures refer to diluted EPS.

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 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 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:

· Acquired loans - Acquired loans are initially recorded at their acquisition date fair values. The carryover of allowance for loan losses is prohibited as any credit losses in the loans are included in the determination of the fair value of the loans at the acquisition date. Fair values for acquired loans are based on a discounted cash flow methodology that involves assumptions and judgments as to credit risk, prepayment risk, liquidity risk, default rates, loss severity, payment speeds, collateral values and discount rate. Subsequent to the acquisition of acquired impaired loans, GAAP requires the continued estimation of expected cash flows to be received. This estimation requires numerous assumptions, interpretations and judgments using internal and third-party credit quality information. Changes in expected cash flows could result in the recognition of impairment through provision for credit losses.

For acquired loans that are not deemed impaired at acquisition, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value. Subsequent to the purchase date, the methods utilized to estimate the required allowance for loan losses for the non-impaired acquired loans is similar to originated loans, however, the Company records a provision for loan losses only when the required allowance exceeds any remaining pooled discounts for loans evaluated collectively for impairment. For loans individually evaluated for impairment, a provision is recoded when the required allowance exceeds any remaining discount on the loan.

· 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 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 ("OTTI"). 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 OTTI 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 of the full value of its amortized cost basis.

· Retirement benefits - The Company provides defined benefit pension benefits to eligible employees and post-retirement health and life insurance benefits to certain eligible retirees. The Company also provides deferred compensation and supplemental executive retirement plans for selected current and former employees and officers. Expense under these plans is charged to current operations and consists of several components of net periodic benefit cost based on various actuarial assumptions regarding future experience under the plans, including, but not limited to, discount rate, rate of future compensation increases, mortality rates, future health care costs 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.

· Intangible assets - As a result of acquisitions, the Company has acquired goodwill and identifiable intangible assets. Goodwill represents the cost of acquired companies in excess of the fair value of net assets at the acquisition date. Goodwill is evaluated at least annually, or when business conditions suggest impairment may have occurred and will be reduced to its carrying value through a charge to earnings if impairment exists. Core deposits and other identifiable intangible assets are amortized to expense over their estimated useful lives. The determination of whether or not impairment exists 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, expected equity market premiums, peer volatility indicators and company-specific risk indicators, all of which are susceptible to change based on changes in economic conditions and other factors. Future events or changes in the estimates used to determine the carrying value of goodwill and identifiable intangible assets could have a material impact on the Company's results of operations.

A summary of the accounting policies used by management is disclosed in Note A, "Summary of Significant Accounting Policies" on pages 54-60 of the most recent Form 10-K (fiscal year ended December 31, 2011) filed with the Securities and Exchange Commission on February 29, 2012.

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 banking subsidiary is Community Bank, N.A. (the "Bank" or "CBNA"), which operates in Pennsylvania under the name First Liberty Bank and Trust.

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 continually improve operating efficiency.

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 April 8, 2011, the Company acquired The Wilber Corporation ("Wilber"), the parent company of Wilber National Bank, for $103 million in stock and cash, comprised of $20.4 million in cash and the issuance of 3.35 million additional shares of the Company's common stock. Based in Oneonta, New York, Wilber operated 22 branches in the Central, Greater Capital District and Catskills regions of Upstate New York. The acquisition added approximately $462 million of loans, $297 million of investment securities and $772 million of deposits.

On November 30, 2011, the Company, through its BPAS subsidiary, acquired certain assets and liabilities of CAI Benefits, Inc. ("CAI") a provider of actuarial, consulting and retirement plan administration services, with offices in New York City and Northern New Jersey. The transaction adds valuable service capacity and enhances distribution prospects in support of the Company's broader-based employee benefits business, including daily valuation plan and collective investment fund administration.

Second quarter and June year-to-date net income of $21.1 million and $39.9 million, respectively, was $3.1 million or 17% and $5.6 million or 17% higher than the respective prior year periods. Earnings per share were $0.53 and $1.01 for the three and six months ended June 30, 2012, an increase of $0.04 and $0.05 from the equivalent prior year periods. The higher net income was due in large part to higher net interest income that resulted from earning asset growth, principally from the continuation of the pre-investing of a portion of the net liquidity received from the HSBC branch acquisition, combined with the Wilber acquisition and organic loan growth, partially offset by a lower net interest margin. Also contributing to higher net income was growth of noninterest income due to incremental deposit service fees from the Wilber acquisition (primarily impacting YTD increase), higher debit card-related revenue, higher employee benefits administration and consulting revenues, primarily driven by the CAI acquisition and solid revenue growth from the wealth management businesses, which benefitted from more favorable market conditions. These were partially offset by a higher provision for loan losses, higher operating expenses for the six month period due in large part to the additional operating costs from the Wilber acquisition, and a higher effective income tax rate. Second quarter and year-to-date 2012 earnings per share were reduced by approximately three and five cents per share, respectively, due to the successful public offering of common stock in January 2012 in which the Company issued 2.13 million shares of its common stock in support of the pending bank branch acquisitions.

Asset quality in the second quarter of 2012 remained stable and favorable in comparison to averages for peer financial organizations. Second quarter loan net charge-off ratios were higher than those experienced in the second quarter of 2011, but consistent with the level of net charge-offs in the first quarter of 2012. Nonperforming loan ratios were higher than experienced in the second quarter of last year, but slightly lower than the first quarter of 2012. The current quarter provision for loan losses was higher than the second quarter of 2011. Delinquency ratios increased from the second quarter of 2011, but were below those experienced in the fourth quarter of 2011. The Company generated year-over-year growth in average interest-earning assets for the quarter, reflective of the pre-investment of approximately $600 million of expected liquidity from the HSBC branch acquisition, as well as organic loan growth. Average deposits in the second quarter of 2012 were higher than the second quarter of 2011 and the fourth quarter of 2011, driven by organic deposit growth. Average borrowings increased during the second quarter of 2012, as the Company pre-invested a portion of the expected liquidity to be derived from the branch acquisitions expected to close in the third quarter of 2012.

On January 19, 2012, Community Bank, N.A. ("the Bank"), the wholly-owned banking subsidiary of the Company, entered into an Assignment, Purchase and Assumption Agreement (the "HSBC Branch Agreement") and a Purchase and Assumption Agreement (the "First Niagara Branch Agreement") (collectively, the "Agreements") with First Niagara Bank, N.A. ("First Niagara"). Under the Agreements, the Bank agreed to acquire 19 branches in Central, Northern, and Western New York, consisting of three branches to be purchased directly from First Niagara and 16 branches to be purchased from HSBC Bank USA, National Association ("HSBC"). First Niagara assigned its rights to the HSBC branches in connection with its pending acquisition of HSBC's Upstate New York banking franchise. On July 20, 2012, the Company completed its acquisition of the 16 retail banking branches owned by HSBC, adding approximately $107 million in loans and $697 million of deposits at a blended deposit premium of 3.4%. Upon the closing, the Company repaid $430 million of overnight borrowings. The acquisition of the three branches owned by First Niagara is expected to close later in the third quarter and will add approximately $72 million of loans and $138 million of deposits also at a blended deposit premium of 3.2%.

The Company completed a public stock offering in late January 2012. The offering raised $57.5 million through the issuance of 2.13 million shares. The net proceeds of the offering were approximately $54.9 million. The Company intends to use the capital raised in this offering to support the HSBC and First Niagara branch acquisitions.

Net Income and Profitability

As shown in Table 1, net income for the second quarter and June YTD of $21.1 million and $39.9 million both increased 17% versus the comparable periods of 2011. Earnings per share for the second quarter of $0.53 were $0.04 higher that the EPS generated in the second quarter of 2011, and earnings per share of $1.01 for the first six months of 2012 increased $0.05 from the amount earned in the first half of 2011. Included in these results were $0.2 million and $0.4 million of acquisition expenses for the three and six months ending June 30, 2012, respectively, as compared to $3.6 million and $4.3 million for the comparative periods of 2011. Earnings per share for both periods grew at a slower pace than net income due to the successful common stock offering in January in support of the pending branch acquisition.

As reflected in Table 1, second quarter net interest income of $57.8 million was up $3.6 million or 6.6% from the comparable prior year period and net interest income for the first six months of 2012 increased $12.0 million or 12% over the first half of 2011. The improvement resulted from an increase in interest-earning assets, primarily due to the continuation of the pre-investing of a portion of the net liquidity expected to be received from the HSBC branch acquisition combined with the Wilber acquisition and organic loan growth, partially offset by a lower net interest margin in the first half of 2012. The current quarter's provision for loan losses increased $1.1 million and $1.7 million as compared to the second quarter and first six months of 2012, reflective of the $2.1 million increase in year-to-date net charge-offs and the continuation of generally stable and favorable asset quality metrics. Second quarter and year-to-date noninterest income was $23.7 million and $47.2 million, respectively, up $0.9 million or 4.2% from the second quarter of 2011 and up $3.6 million or 8.2% from the first six months of 2011, primarily due to the Wilber and CAI acquisitions. Contributing to the increase was a $1.3 million increase in revenue generated from the Company's wealth management group, principally from activities related to the trust operations acquired from Wilber, as well as solid organic growth aided by more favorable market conditions.

Operating expenses of $49.4 million for the second quarter decreased $1.8 million or 3.4% from the comparable prior year period. Excluding acquisition expenses of $0.2 million in the second quarter of 2012 and $3.6 million in the second quarter of 2011, operating expenses increased $1.7 million or 3.6%. Operating expenses for the first six months of 2012 were $4.3 million or 4.6% higher than the first six months of 2011. Excluding acquisition expenses of $0.4 million and $4.3 million in the first six months of 2012 and 2011, respectively, operating expenses increased $8.2 million or 9.1%. The increase in operating expenses, excluding acquisition related expenses, is reflective of additional operating costs associated with the Wilber and CAI acquisitions completed in April and November of 2011, respectively, partially offset by lower FDIC insurance costs and business development and marketing expenses.

A condensed income statement is as follows:

Table 1: Condensed Income Statements

                                           Three Months Ended    Six Months Ended
                                                June 30,             June 30,
    (000's omitted, except per share
    data)                                    2012      2011        2012     2011
    Net interest income                     $57,771   $54,187    $111,680  $99,710
    Provision for loan losses                 2,155     1,050       3,799    2,100
    Noninterest income                       23,696    22,751      47,164   43,593
    Gain on sale of investment
    securities & debt extinguishment,
    net                                           0        14           0       14
    Operating expenses                       49,370    51,126      98,773   94,442
    Income before taxes                      29,942    24,776      56,272   46,775
    Income taxes                              8,871     6,790      16,375   12,629
    Net income                              $21,071   $17,986     $39,897  $34,146

    Diluted weighted average common
    shares outstanding                       40,057    37,061      39,692   35,564
    Diluted earnings per share                $0.53     $0.49       $1.01    $0.96

Net Interest Income

Net interest income is the amount by which interest and fees on earning assets (loans, investments and cash equivalents) exceed the cost of funds, primarily interest paid to the Company's depositors and interest on external borrowings. Net interest margin is the difference between the gross yield on earning assets and the cost of interest-bearing funds as a percentage of earning assets.

As shown in Table 2a, net interest income (with nontaxable income converted to a fully tax-equivalent basis) for the second quarter of 2012 was $62.1 million, a $3.9 million or 6.7% increase from the same period last year. The increase was a result of a $647.8 million increase in second quarter interest-earning assets versus the prior year having a greater impact than the $482.2 million increase in average interest-bearing liabilities and a 17-basis point decrease in the net interest margin. As reflected in Table 3, the second quarter volume increase from interest-bearing assets combined with the rate decrease on interest-bearing liabilities had a $12.4 million favorable impact on net interest income, while the rate decrease on interest-bearing assets and the volume increase on interest bearing liabilities had a $8.5 million unfavorable impact on net interest income. June 2012 YTD net interest income of $120.0 million increased $12.3 million or 11.5% from the year-earlier period. An $805.1 million increase in interest-earning assets had a greater impact than the $618.6 million increase in average interest-bearing liabilities and a 14-basis point decrease in net interest margin. The increase in interest-earning assets and the lower rate on interest-bearing liabilities had a $27.9 million favorable impact that was partially offset by a $15.5 million unfavorable impact from the decrease in the yield on interest-bearing assets and the increase in interest-bearing liability balances.

Average investments, including cash equivalents, for the second quarter and YTD periods were $589.7 million and $553.1 million higher than the comparable periods of 2011, reflective of the purchase of approximately $600 million of U.S. Treasury securities late in the first quarter of 2012 and the acquired Wilber portfolio. The Company actively redeployed maturing loan and investment cash flows and excess funding supplied by deposit growth, and as well as the pre-investment of a portion of the excess liquidity expected from the pending branch acquisition. Second quarter 2012 average loan balances increased $58.2 million as compared to the second quarter of 2011 due to organic loan growth principally in the consumer mortgage and indirect portfolios. Year-to-date average loans increased $252.0 million due to the impact of the acquired Wilber loans and $53.9 million of organic growth, principally in the consumer mortgage and indirect portfolios. In comparison to the prior year, total average interest-bearing deposits were up $138.5 million or 3.6%, and $432.1 million or 12%, for the quarter and YTD periods, respectively, as a result of the Wilber acquisition and organic growth. Quarterly and YTD average borrowings increased $343.7 million or 41% and $186.5 million or 22%, respectively, reflective of the initiative to pre-invest a portion of the liquidity expected from the branch acquisitions in the third quarter of 2012.

The net interest margin of 3.96% for the second quarter and YTD period decreased 17 basis points and 14 basis points as compared to the second quarter and first six months of 2011, respectively, but remained consistent with the first quarter of 2012. Earning asset yields declined by 46 basis points and 43 basis points for the quarter and year-to-date periods, respectively, reflective of lower yields on loans and investment securities. This was partially offset by continued disciplined deposit pricing, the expiration of the interest rate swap agreement on the trust preferred securities and the addition of low-rate overnight borrowings, resulting in a 30-basis point and 29-basis point reduction in the total cost of funds in comparison to the second quarter and year-to-date periods of 2011, respectively.

The decrease in the earning-asset yield was attributable to a 43-basis point and 55-basis point decrease in investment yields, including cash equivalents, for the quarter and YTD period as compared to the prior year periods, largely a result of the purchase of $868 million of U.S. Treasury, obligations of state and political subdivisions and other securities with an average yield of 2.69% during the first half of 2012. Additionally, contributing to the decrease in earning-asset yield for the quarter was a 35-basis point and 26-basis point decline in the loan yield as compared to the second quarter and YTD periods of 2011, as a result of lower rates on fixed-rate new loan volume due to the decline in interest rates to levels below those prevalent in prior years and certain existing adjustable and fixed-rate loans repricing downward.

The second quarter cost of funds decreased versus the prior year quarter due to a 26-basis point decrease in interest-bearing deposit rates, a higher proportion of funding being supplied from low and noninterest bearing deposits and a 139-basis point decrease in the average interest rate paid on external borrowings. The decreases in the cost of funds were reflective of disciplined deposit pricing, whereby interest rates on selected categories of deposit accounts were lowered throughout 2011 and the first six months of 2012 in response to market conditions. Additionally, the proportion of customer deposits held in higher cost time deposits has continued to decline over the last twelve months. The decrease in the average rate paid on external borrowings was primarily due to the maturing of the interest rate swap in December of 2011, which had converted the variable rate trust preferred securities into a fixed rate obligation at 6.43% for a term of five years, and the utilization of low-rate overnight borrowings to fund acquisition related investment activity.

Table 2 below sets forth information related to average interest-earning assets and interest-bearing liabilities and their associated yields and rates for the periods indicated. Interest income and yields are on a fully tax-equivalent basis ("FTE") using a marginal income tax rate of 38.79% and 38.53% in 2012 and 2011, respectively. 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, deferred loan costs and accretion of acquired loan marks. Average loan balances include nonaccrual loans and loans held for sale.

Table 2a: Quarterly Average Balance Sheet

                                           Three Months Ended               Three Months Ended
. . .