(Dollar amounts in thousands except per share data)

Overview

MainSource Financial Group, Inc. ("MainSource or Company") is a financial holding company whose principal activity is the ownership and management of its subsidiary bank, MainSource Bank ("Bank") headquartered in Greensburg, Indiana, and MainSource Title, LLC ("MST"). The Bank operates under a state charter and is subject to regulation by its state regulatory agencies and the Federal Deposit Insurance Corporation. MST is subject to regulation by the Indiana Department of Insurance.

Forward-Looking Statements

Except for historical information contained herein, the discussion in this report includes certain forward-looking statements based upon management expectations. Actual results and experience could differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. The Company disclaims any intent or obligation to update such forward looking statements. Factors which could cause future results to differ from these expectations include the following: general economic conditions; legislative and regulatory initiatives; monetary and fiscal policies of the federal government; deposit flows; the cost of funds; general market rates of interest; interest rates on competing investments; demand for loan products; demand for financial services; changes in accounting policies or guidelines; changes in the quality or composition of the Company's loan and investment portfolios; the Company's ability to integrate acquisitions, the impact of our continuing acquisition strategy, and other factors, including the risk factors set forth in Item 1A of the Company's Annual Report on Form 10-K for the year ended December 31, 2011, and in other reports we file from time to time with the Securities and Exchange Commission. The Company intends the forward looking statements set forth herein to be covered by the safe harbor provisions for forward looking statements contained in the Private Securities Litigation Reform Act of 1995.

Results of Operations

Net income for the second quarter of 2012 was $6,982 compared to net income of $7,626 for the second quarter of 2011. The decrease in net income was primarily attributable to securities gains of $2,521 taken by the Company in the second quarter of 2011 compared to $48 in the second quarter of 2012. Offsetting these gains was a decrease in loan loss provision expense of $1,500 and an increase in mortgage banking income of $902. Diluted earnings per common share for the second quarter totaled $0.32 in 2012, a decrease from the $0.34 reported in the same period a year ago. Key measures of the financial performance of the Company are return on average shareholders' equity and return on average assets. Return on average shareholders' equity was 8.67% for the second quarter of 2012 while return on average assets was 1.00% for the same period, compared to 9.75% and 1.08% in the second quarter of 2011.

For the six months ended June 30, 2012, net income was $12,993 compared to net income of $12,172 for the same period a year ago. The slight increase in net income was also primarily attributable to a decrease in the Company's loan loss provision expense of $4,000 from 2011 and an increase in mortgage banking income of $1,699 offset by a decrease in net interest income of $2,812 and a decrease in securities gains of $3,119. Earnings per share increased to $.58 for the first six months of 2012 from $.53 for the same period in 2011. Return on average shareholders' equity was 7.86% for the first six months of 2012 while return on average assets was 0.94% for the same period, compared to 7.94% and 0.88% in the first six months of 2011.

Net Interest Income

The volume and yield of earning assets and interest-bearing liabilities influence net interest income. Net interest income reflects the mix of interest-bearing and non-interest-bearing liabilities that fund earning assets, as well as interest spreads between the rates earned on these assets and the rates paid on interest-bearing liabilities. Second quarter net interest income of $23,750 in 2012 was a slight decrease of 6.5% versus the second quarter of 2011. Average earning assets decreased $32 million with the majority of the decrease the result of reduced loan balances of $75 million. Offsetting this decrease in loans was an increase in the investment portfolio of $61 million. Also affecting margin was an increase in average demand deposits, NOW accounts, and savings accounts of $144 million which offset a decrease in higher costing CD and money market accounts of $183 million. Net interest margin, on a fully-taxable equivalent basis, was 4.05% for the second quarter of 2012, a twenty basis point decrease compared to 4.25% for the same period a year ago and a twelve basis point decrease on a linked quarter basis.

For the first six months of 2012, the Company's net interest margin was 4.11% compared to 4.28% for the first six months of 2011.

Provision for Loan Losses

See "Loans, Credit Risk and the Allowance and Provision for Probable Loan Losses" below.

Non-interest Income

Second quarter non-interest income for 2012 was $10,743 compared to $11,520 for the second quarter of 2011. Contributing to the decrease of $777 was a net decrease in securities gains of $2,473 offset by an increase in mortgage banking of $902, service charges (primarily overdraft fees) of $393 and interchange income of $168. Continued organic growth in deposit accounts has resulted in higher fee and interchange income. The continued low interest rate environment has resulted in continued refinancing activities and an increase in mortgage banking income.

For the six months ended June 30, 2012, non-interest income was $20,565 compared to $20,839 for the same period a year ago. Contributing to the decrease of $274 was a net decrease in securities gains of $3,119 and other income of $431. The primary cause of the other income decrease was the write down of the book value of six branches that the Board of Directors voted to close effective in the third quarter of 2012. (See Note 12 in the Notes to the Consolidated Financial Statements). Offsetting these decreases were increases in mortgage banking income of $1,699, service charges on deposit accounts of $871, interchange income of $402, and two write downs of ORE property of $388 taken in the first quarter of 2011.

Non-interest Expense

The Company's non-interest expense was $23,442 for the second quarter of 2012, compared to $23,383 for the same period in 2011. The primary increase was in equipment costs of $221 offset by a reduction in the FDIC assessment of $395. The Company's FDIC premium decreased as a result of its exit from its informal agreement with the FDIC and Indiana DFI during the first quarter of 2012, as well as a change in methodology. The Company's efficiency ratio was 64.7% for the second quarter of 2012 compared to 60.4% for the same period a year ago.

For the six months ended June 30, 2012, non-interest expense was $46,723 compared to $47,203 for the same period a year ago. The primary decreases were in salaries and employee benefits of $622, the aforementioned FDIC assessment of $748, and marketing expenses of $265. The reduction in employee costs is a direct result of the efficiency initiatives completed by the Company in 2011. The reduction in marketing expenses was due to start up costs involved in 2011 for a checking account acquisition program and a customer/employee engagement survey and improvement program. Offsetting these decreases were increases in equipment expenses of $325 and other expenses of $887. Other expenses increased primarily due to the expenses related to the Treasury's auction of its Series A Preferred Stock in the Company and the Company's bid to purchase such stock and costs related to the closing of six branches announced in the first quarter of 2012. The Company's efficiency ratio was 65.3% for the first six months of 2012 compared to 63.2% for the same period a year ago.

Income Taxes

The effective tax rate for the second quarter of 2012 was 18.3% versus 20.0% for the same period 2011. The slight decrease was due to the decrease in pre-tax income in the second quarter of 2012.

The effective tax rate for the first six months was 17.6% for 2012 compared to 15.3% for the same period a year ago. The increase in the effective tax rate was due to the increase in GAAP income before taxes while the Company's tax exempt income and credits remained relatively consistent with prior periods. The Company and its subsidiaries file consolidated income tax returns.

Financial Condition

Total assets at June 30, 2012 were $2,766,633, a slight increase from total assets of $2,754,180 as of December 31, 2011. The individual components of the asset side of the balance sheet remained basically the same as the balances at December 31, 2011. This included loan balances which had decreased approximately $150 million in 2011. Gross loan balances increased $12,131 from their December 31, 2011 balance. Average earning assets represented 90.1% of average total assets for the first six months of 2012 and 90.8% for the same period in 2011. Average loans represented 71.4% of average deposits in the first six months of 2012 and 74.1% for the comparable period in 2011. Management continues to emphasize quality loan growth to increase these averages. Average loans as a percent of average assets were 56.1% and 59.1% for the six month periods ended June 30, 2012 and 2011 respectively.

Deposits increased $25 million from December 31, 2011. The increase in noninterest bearing deposits and interest bearing demand deposits of $93 million more than offset a reduction of higher priced CD balances of $54 million and savings balances of $14 million.

Shareholders' equity was $330 million on June 30, 2012 compared to $337 million on December 31, 2011. Book value (shareholders' equity) per common share was $14.60 at June 30, 2012 versus $13.87 at year-end 2011. Accumulated other comprehensive income increased book value per share by $1.27 at June 30, 2012 and increased book value per share by $1.13 at December 31, 2011. Depending on market conditions, the unrealized gain or loss on securities available for sale can cause fluctuations in shareholders' equity. As mentioned in Note 11, the Company was able to buy back and retire $23 million of its preferred shares in the first six months of 2012 at a discount.

Loans, Credit Risk and the Allowance and Provision for Probable Loan Losses

Loans remain the Company's largest concentration of assets and, by their nature, carry a higher degree of risk. The loan underwriting standards observed by the Bank are viewed by management as a means of controlling problem loans and the resulting charge-offs. The Company believes credit risks may be elevated if undue concentrations of loans in specific industry segments and to out-of-area borrowers are incurred. Accordingly, the Company's Board of Directors regularly monitors such concentrations to determine compliance with its loan allocation policy. The Company believes it has no undue concentrations of loans.

Management maintains a list of loans warranting either the assignment of a specific reserve amount or other special administrative attention. This watch list, together with a listing of all classified loans, nonaccrual loans and delinquent loans, is reviewed monthly by management and the Board of Directors. Additionally, the Company evaluates its consumer and residential real estate loan pools for probable losses incurred based on historical trends, adjusted by current delinquency and non-performing loan levels.

The Company has both internal and external loan review personnel who annually review approximately 50% of all loans. External loan review personnel examine the top 100 commercial credit relationships. This equates to approximately all relationships above $1,750.

The ability to absorb loan losses promptly when problems are identified is invaluable to a banking organization. Most often, losses incurred as a result of prompt, aggressive collection actions are much lower than losses incurred after prolonged legal proceedings. Accordingly, the Company observes the practice of quickly initiating stringent collection efforts in the early stages of loan delinquency. During the latter part of 2008, the Company established a separate group to address its deteriorating credit quality. This group consists of six full-time equivalent employees and reports directly to the Chief Credit Officer of the Company. At the present time, this group is charged with the task of efficiently resolving non-performing credits and disposing of foreclosed properties.

Total loans (excluding loans held for sale) increased $12,131 from year end 2011. The Company is experiencing improving overall demand across all segments. Residential real estate loans continue to represent a significant portion of the total loan portfolio. Such loans represented 24.7% of total loans at June 30, 2012 and 23.8% at December 31, 2011. The Company anticipates this category of loans to decrease as a large portion of future residential real estate loan originations will be sold to the secondary market. On June 30, 2012, the Company had $10,878 of residential real estate loans held for sale, which was a decrease from the year-end balance of $16,620. The Company generally retains the servicing rights on mortgages sold.

Loans are placed on "non-accrual" status when, in management's judgment, the collateral value and/or the borrower's financial condition does not justify accruing interest. As a general rule, commercial and real estate loans are reclassified to nonaccrual status at or before becoming 90 days past due. Interest previously recorded is reversed and charged against current income. Subsequent interest payments collected on nonaccrual loans are thereafter applied as a reduction of the loan's principal balance. Non-performing loans were as follows (non-accrual loans + loans past due 90 days and still accruing + troubled debt restructurings):

                         June 30, 2012     March 31, 2012      December 31, 2011      September 30, 2011      June 30, 2011
Amount                  $        54,944    $        52,677    $            65,197    $             65,231    $        58,919
Percent of loans                   3.55 %             3.44 %                 4.25 %                  4.18 %             3.65 %

The increase of $2 million from March 31 2012 was primarily driven by the downgrade of two substandard loans to non-accrual status. Of the $54,944 of non-performing loans at June 30, 2012, $20,550 had a specific reserve allocated of $6,974.

A reconciliation of the non-performing assets for the first six months of 2012 is as follows:

                                              2012       2011
Beginning Balance - NPA - January 1, 2012   $ 80,732   $ 102,998
Non-accrual
Add: New non-accruals                         20,589      21,685
Less: To accrual/payoff/restructured          (5,013 )   (22,989 )
Less: To OREO                                 (2,946 )   (13,660 )
Less: Charge offs                             (7,200 )   (10,743 )
Increase/(Decrease): Non-accrual loans         5,430     (25,707 )
Other Real Estate Owned (OREO)
Add: New OREO properties                       2,946      13,660
Less: OREO sold                               (8,022 )   (10,228 )
Less: OREO losses (write-downs)                 (643 )      (561 )
Increase/(Decrease): OREO                     (5,719 )     2,871
Increase/(Decrease): 90 Days Delinquent       (3,232 )      (886 )
Increase/(Decrease): Repossessions               (79 )       (26 )
Increase/(Decrease): TDR's                   (12,451 )    (6,007 )
Total NPA change                             (16,051 )   (29,755 )
Ending Balance - NPA - June 30, 2012        $ 64,681   $  73,243

At June 30, 2012, two of the non-accrual loan balances were greater than $1,000 compared to one loan balance greater than $1,000 at December 31, 2011. These loans are primarily land development and real estate backed loans. The Company is working with these borrowers in an attempt to minimize its losses. In the course of resolving nonperforming loans, the Company may choose to restructure the contractual terms of certain loans. The Company attempts to work out an alternative payment schedule with the borrower in order to avoid foreclosure actions and mitigate loss to the Bank. Any loans that are modified are reviewed by us to identify if a troubled debt restructuring has occurred, which is when for economic or legal reasons related to a borrower's financial difficulties, the Company grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status and could include reduction of the stated interest rate other than normal market rate adjustments, extension of maturity dates, or reduction of principal balance or accrued interest. The decision to restructure a loan, versus aggressively enforcing the collection of the loan, may benefit us by increasing the ultimate probability of collection. The Company reviews each relationship before it grants the concession to insure the creditor can comply with the new terms. To date, most of the concessions have been extensions of maturity dates.

During the first six months of 2012, the Company experienced a $60 million reduction in its Special Mention loans in the commercial portfolio. 50% of the decrease was in the Hotel category and 40% in Other Real Estate. Approximately 75% of these loans were upgraded during the first six months with 25% experiencing deterioration and were downgraded.

The provision for loan losses was $2,500 in the second quarter of 2012 compared to $4,000 for the same period in 2011 and $3,100 for the first quarter of 2012. For the first six months of 2012 and 2011, the provision for loan loss was $5,600 and $9,600 respectively. The decrease in provision expense from 2011 was primarily due to the relative stabilization in the amount of non-performing and watch list loans in aggregate and decrease in net charge-offs. The amount of new non-accrual loans in the second quarter of 2012 was approximately $1,000 higher than the first quarter of 2012.

Net loan losses were $2,752 for the second quarter of 2012 compared to $5,793 for the same period a year ago and $7,200 for the first six months of 2012 compared to $10,743 a year ago. Approximately 60% of the Company's charge-offs for the first six months of 2012 was related to 8 commercial credits. All but approximately $1,267 of these charge-offs had an allowance allocated in 2011 or prior.

The adequacy of the allowance for loan losses is reviewed at least quarterly. The determination of the provision amount in any period is based upon management's continuing review and evaluation of loan loss experience, changes in the composition of the loan portfolio, classified loans including non-accrual and impaired loans, current economic conditions, the amount of loans presently outstanding, and the amount and composition of loan growth. The allowance for loan losses as of June 30, 2012 was considered adequate by management. The allowance for loan losses was $38,289 as of June 30, 2012 and represented 2.48% of total outstanding loans compared to $39,889 as of December 31, 2011 or 2.60% of total outstanding loans. The slight decrease in the percentage was due to an improvement in nonperforming assets for the six month period ending June 30, 2012.

Investment Securities

Investment securities offer flexibility in the Company's management of interest rate risk and are an important source of liquidity as a response to changing characteristics of assets and liabilities. The Company's investment policy prohibits trading activities and does not allow investment in high-risk derivative products, junk bonds or foreign investments.

As of June 30, 2012, the Company had $896,037 of investment securities. All of these securities were classified as "available for sale" ("AFS") and were carried at fair value with unrealized gains and losses, net of taxes, reported as a separate component of shareholders' equity. An unrealized pre-tax gain of $39,504 was recorded to adjust the AFS portfolio to current market value at June 30, 2012, compared to an unrealized pre-tax gain of $35,218 at December 31, 2011. Unrealized losses on AFS securities have not been recognized into income because management does not intend to sell and does not expect to be required to sell these securities for the foreseeable future and the decline in fair value is largely due to temporary illiquidity and the financial crisis affecting these markets and not necessarily the expected cash flows of the individual securities. The fair value is expected to recover as the securities approach their maturity dates. All securities in the Company's portfolio are performing as expected with no disruption in cash flows and all rated securities are rated investment grade.

Sources of Funds

The Company relies primarily on customer deposits, securities sold under agreements to repurchase and shareholders' equity to fund earning assets. FHLB advances are also used to provide additional funding.

Deposits generated within local markets provide the major source of funding for earning assets. Average total deposits funded 87.2% and 87.9% of total average earning assets for the six-month periods ending June 30, 2012 and 2011. Total interest-bearing deposits averaged 84.6% and 87.5% of average total deposits for the six-month periods ending June 30, 2012 and 2011, respectively. Management constantly strives to increase the percentage of transaction-related deposits to total deposits due to the positive effect on earnings.

The Company had FHLB advances of $146,150 outstanding at June 30, 2012. These advances have interest rates ranging from 1.84% to 5.90%. All of the current advances were originally long-term advances with approximately $16,000 maturing in 2012, $15,000 maturing in 2013, $25,000 maturing in 2014, $10,000 maturing in 2015, and $80,000 maturing in 2016 and beyond.

Capital Resources

Total shareholders' equity was $329,858 at June 30, 2012, which was a decrease of $6,695 compared to the $336,553 of shareholders' equity at December 31, 2011. The decrease in shareholders' equity was primarily attributable to the Company's purchase and retirement of a portion of its preferred shares of $22,626, and payment of preferred and common dividends of $1,154 and $405 respectively, offset by net income of $12,993 for the first six months of 2012, other comprehensive income of $2,785 for the first six months of 2012, and an increase in retained earnings of $1,302 as a result of buying the preferred stock at less than par value.

The Federal Reserve Board and other regulatory agencies have adopted risk-based capital guidelines that assign risk weightings to assets and off-balance sheet items. The Company's core capital consists of shareholders' equity, excluding accumulated other comprehensive income/loss, while Tier 1 capital consists of core capital less goodwill and intangibles. Trust preferred securities qualify as Tier 1 capital or core capital with respect to the Company under the risk-based capital guidelines established by the Federal Reserve. Under such guidelines, capital received from the proceeds of the sale of trust preferred securities cannot constitute more than 25% of the total core capital of the Company. Consequently, the amount of trust preferred securities in excess of the 25% limitation constitutes Tier 2 capital of the Company. Total regulatory capital consists of Tier 1, certain debt instruments and a portion of the allowance for loan losses. At June 30, 2012, Tier 1 capital to total average assets was 10.4%. Tier 1 capital to risk-adjusted assets was 17.2%. Total capital to risk-adjusted assets was 18.5%. All three ratios exceed all required ratios established for bank holding companies. Risk-adjusted capital levels of the Bank exceed regulatory definitions of well-capitalized institutions.

The Company declared and paid common dividends of $0.01 per share in the second quarter of 2012 versus $0.01 for the second quarter of 2011. To prudently manage capital, the Company elected to reduce its dividend starting in the second quarter of 2009. However, the Company announced that its third quarter 2012 dividend will increase to $0.03 per share.

Liquidity

Liquidity management involves maintaining sufficient cash levels to fund operations and to meet the requirements of borrowers, depositors, and creditors. Higher levels of liquidity bear higher corresponding costs, measured in terms of lower yields on short-term, more liquid earning assets, and higher interest expense involved in extending liability maturities. Liquid assets include cash and cash equivalents, loans and securities maturing within one year, and money market instruments. In addition, the Company holds AFS securities maturing after one year, which can be sold to meet liquidity needs.

Maintaining a relatively stable funding base, which is achieved by diversifying funding sources and extending the contractual maturity of liabilities, supports liquidity and limits reliance on volatile short-term purchased funds. Short-term funding needs arise from declines in deposits or other funding sources, funding of loan commitments and requests for new loans. The Company's strategy is to fund assets to the maximum extent possible with core deposits that provide a sizable source of relatively stable and low-cost funds. Average core deposits funded approximately 80.3% of total earning assets for the six months ended June 30, 2012 and 79.3% for the same period in 2011.

Management believes the Company has sufficient liquidity to meet all reasonable borrower, depositor, and creditor needs in the present economic environment. In addition, the Bank has access to the Federal Home Loan Bank for borrowing purposes.

Interest Rate Risk

Asset/liability management strategies are developed by the Company to manage market risk. Market risk is the risk of loss in financial instruments including investments, loans, deposits and borrowings arising from adverse changes in prices/rates. Interest rate risk is the Company's primary market risk exposure, and represents the sensitivity of earnings to changes in market interest rates.

Effective asset/liability management requires the maintenance of a proper ratio between maturing or repriceable interest-earning assets and interest-bearing liabilities. In an effort to estimate the impact of sustained interest rate movements to the Company's earnings, the Company monitors interest rate risk through computer-assisted simulation modeling of its net interest income. The Company's simulation modeling monitors the potential impact to net interest income under various interest rate scenarios. The Company's objective is to actively manage its asset/liability position within a one-year interval and to limit the risk in any of the interest rate scenarios to a reasonable level of tax-equivalent net interest income within that interval.