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 Accounting Standards Codification ("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 $110,000 for the three month period ended June 30, 2012 and $679,000 for the same period in 2011. For the six month periods ended June 30, 2012 and 2011 the Bank recorded provisions of $277,000 and $1.2 million, respectively. 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 $7.0 million for the six months ended June 30, 2012. For the same period, the Bank recorded charge-offs of $603,000 and recovered $52,000 on previously charged-off loans. As of June 30, 2012, the Bank's allowance for credit losses was $6.9 million or 2.32% of total loans and 94.0% of nonperforming loans as compared to $7.2 million, or 2.47% of total loans and 102.0% 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 six months ended June 30, 2012 and 2011 is shown below:

(dollars in thousands)                                         For the Six Months
                                                                 Ended June 30,
                                                              2012           2011
Total loans outstanding - at June 30                        $ 297,384      $ 290,140
Average loans outstanding year-to-date                        298,192        285,091
Allowance for credit losses at beginning of period          $   7,182      $   6,853

Provision charged to expense                                      277          1,236

Chargeoffs:
Commercial loans                                                   32            772
Real estate and construction loans                                341            182
Consumer and other loans                                          230            136

Total                                                             603          1,090

Recoveries:
Commercial loans                                                   28             10
Real estate and construction loans                                  4            253
Consumer and other loans                                           20             10

Total                                                              52            273

Net chargeoffs                                                    551            817

Allowance for credit losses at end of period                $   6,908      $   7,272

Allowance for credit losses as a percent of total loans          2.32 %         2.51 %
Net chargeoffs (recoveries) as a percent of average loans        0.18 %         0.29 %

The Bank's nonperforming assets, which are comprised of loans delinquent 90 days or more, non-accrual loans, accruing troubled debt restructurings, loans with repossessed collateral and repossessed assets, totaled $8.6 million at June 30, 2012, compared to $8.3 million at December 31, 2011, an increase in nonperforming assets of $322,000 or 3.9%. The percentage of nonperforming assets to total assets was 1.97% at June 30, 2012, compared to 1.88% at December 31, 2011. The increase in nonperforming assets was principally attributable to additions to nonperforming of $1.1 million offset by sales, payoffs and pay-downs of nonperforming assets of $318,000, and to charge-offs and additional write-downs on loans previously classified as nonperforming of $452,000.

The $8.6 million in nonperforming assets at June 30, 2012 included $6.2 million in nonaccrual loans, $852,000 in accruing troubled debt restructurings, $285,000 of loans past due greater than 90 days and still accruing and $1.3 million in other assets. Of the $6.2 million in nonaccrual loans at June 30, 2012, $5.5 million were secured by real estate, $598,000 were commercial loans and $147,000 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.

The following table shows the amounts of nonperforming assets at June 30, 2012 and December 31, 2011:

                                                          June 30,            December 31,
                                                            2012                  2011
Nonaccrual loans:
Commercial                                               $      598          $          390
Real estate                                                   5,467                   5,308
Consumer                                                        147                     484
Accrual loans - past due 90 days
Real estate                                                     285                       0
Restructured loans                                              852                     856

Total nonperforming loans                                     7,349                   7,038
Real estate owned                                             1,169                   1,222
Repossessed assets                                              116                      52

Total nonperforming assets                               $    8,634          $        8,312

Allowance for credit losses to total nonperforming
loans                                                         94.00 %                102.03 %
Ratio of nonperforming loans to total loans                    2.47 %                  2.42 %
Ratio of nonperforming assets to total assets                  1.97 %                  1.88 %

Comparison of Financial Condition at June 30, 2012 and December 31, 2011

Total assets of $437.5 million at June 30, 2012 decreased 0.93% or $4.1 million compared to $441.6 million at December 31, 2011. The contraction of the balance sheet was the result of redeeming 50% of the TARP balance of outstanding Series A Preferred Stock for a total of $4.1 million. Loan demand improved in the first six months of 2012, with $297.8 million of gross loans as of June 30, 2012, an increase of $7.0 million from $290.8 million at December 31, 2011. The increase resulted primarily from the origination, net of payments of approximately $8.5 million in real estate secured loans offset by charge-offs of $603,000 and payments and payoffs totaling $900,000 of commercial and installment loans. Interest bearing balances with banks increased $10.6 million while federal funds sold as of June 30, 2012 decreased $26.6 million from December 31, 2011. Investment securities increased $3.4 million or 3.9% compared to December 31, 2011.

Deposits of $343.2 million at June 30, 2012 decreased $7.2 million or 2.1% from December 31, 2011 deposits of $350.4 million. Savings balances decreased $5.4 million while certificate of deposit balances decreased $5.5 million due to higher rate certificates of deposit maturing and not renewing at current lower yield levels. Money market balances increased $4.4 million.

Comparison of Operating Results for the Six Months Ended June 30, 2012 and 2011.

General.The Company recorded net income of $1.7 million for the six months ended June 30, 2012; an increase of $910,000, compared to net income of $835,000 for the six months ended June 30, 2011, an increase of $109.0%. Net income available to common shareholders for the six months ended June 30, 2012 was $1.6 million or $0.40 per basic and $0.39 per diluted common shares compared to net income available to common shareholders of $590,000 or $0.15 per basic and diluted common shares for the six months ended June 30, 2011. Net interest income increased by $78,000 or 1.0% for the six months ended June 30, 2012 compared to the same period in 2011. The provision for credit losses decreased $959,000 to $277,000 for the six months ended June 30, 2012 compared to $1.2 million for the six month period ended June 30, 2011.

Interest Income. Total interest income decreased $283,000 or 2.9% for the six months ended June 30, 2012 compared to the same period in 2011 as a result of lower yields obtained on new loans and investments. Interest income on investment securities decreased $316,000. The yield on the investment portfolio decreased to 2.47% from 3.01% on balances $5.7 million lower on average over the same period in 2011. Income on the loan portfolio increased $20,000 for the six months ended June 30, 2012 due to an increase in average loan balances of $13.1 million offset by lower loan yields. The yield on the loan portfolio decreased to 5.70% for the six months ended June 30, 2012 from 5.98% for the six months ended June 30, 2011.

Interest Expense. Total interest expense decreased by $361,000 or 19.3% for the six months ended June 30, 2012 compared to the six months ended June 30, 2011. The decrease was due to reducing the yields on the Company's deposit and repurchase agreement accounts. The Company's savings accounts, the largest of the deposit balances, had an average balance of $133.3 million for the six months ended June 30, 2012 and a yield of 0.35% compared to an average balance of $139.9 million and a yield of 0.73% for the six months ended June 30, 2011. The average rate of interest paid on all interest bearing liabilities was 0.88% for the six months ended June 30, 2012 compared to 1.08% for the six months ended June 30, 2011. Interest expense on long-term borrowings and junior subordinated debentures was $655,000 for the six months ended June 30, 2012 compared to $646,000 for the six months ended June 30, 2011. The increase resulted from a rise in the yield on the junior subordinated debentures to 3.68% from 3.51%.

Net Interest Income. Net interest income increased by $78,000 or 1.0% for the six months ended June 30, 2012 compared to the six months ended June 30, 2011. The increase was primarily the result of lower overall cost of deposits. The Company's cost of funds decreased to 0.75% for the six months ended June 30, 2012 compared to 0.96% for the six months ended June 30, 2011.

For the six months ended June 30, 2012, the net interest margin decreased to 3.86% compared to 3.95% for the six months ended June 30, 2011. The decrease in net interest margin was primarily the result of the decrease in the yield on earnings assets which decreased to 4.58% for the six months ended June 30, 2012 from 4.87% for the same period in 2011.

Provision for Credit Losses. The Bank recorded a provision for credit losses of $277,000 for the six months ended June 30, 2012 compared to $1.2 million for the same period in 2011. The provision was based on the composition and credit quality of the loan portfolio as of June 30, 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 $7.0 million for the six month period ended June 30, 2012 compared to December 31, 2011. The Bank recorded net charge-offs on loans deemed uncollectible of $603,000 for the six months ended June 30, 2012 compared to $817,000 for the same period in 2011.

Noninterest Income. Total noninterest income for the six months ended June 30, 2012 increased by $179,000 or 24.7% to $903,000 from $724,000 for the same period in 2011. The increase in noninterest income was due to higher mortgage and lending fees of $22,000 and gains on the sale of real estate owned. The six months ended June 30, 2011 included losses of $32,000 on the write-down of fixed assets relating to the closure of a branch office. There were no such write-downs for the six months ended June 30, 2012.

Noninterest Expense. Total noninterest expense decreased by $327,000 or 5.2% for the six months ended June 30, 2012 compared to the same period in 2011. The decrease in total noninterest expense during the first six months of 2012 compared with the same period in 2011 resulted from decreased personnel, occupancy and equipment and FDIC expense. Offsetting these decrease in noninterest expense was an increase in legal expense related to loan collections. Personnel expense decreased $168,000 for the six month period due to vacated staff positions that have not been refilled. Occupancy and equipment expense decreased as the same period in 2011 included accelerated depreciation relating to the Market House branch closure. FDIC expense decreased $113,000 for the six months ended June 30, 2012 compared to June 30, 2011 due to the impact of the changes in the assessment formula. Legal collection fees increased for 2012 as 2011 results included the reimbursement of legal costs from the payoff of a loan previously classified as nonperforming.

Income Tax Expense. The Company recorded income tax expense for the six-month period ended June 30, 2012 of $1.0 million compared to $406,000 for the six months ended June 30, 2011. The Company's combined effective federal and state income tax rate was approximately 37.3% for the six months ended June 30, 2012 versus 32.7% for the six months ended June 30, 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)                                  Six Months Ended June 30, 2012 vs. 2011
                                                                              Due to Change in
                                              Increase or                                           Rate/
                                              (Decrease)            Volume           Rate          Volume
Interest income on:
Loans                                        $          20         $    389           ($353 )         ($16 )
Investment securities                                 (316 )            (86 )          (245 )           15
Interest bearing balances with banks                     6               (1 )             7              0
Federal funds sold and other overnight
investments                                              7                5               2              0

Total interest income                                 (283 )            307            (589 )           (1 )
Interest expense on:
NOW accounts                                            (7 )              0              (7 )            0
Money market accounts                                  (27 )             25             (42 )          (10 )
Savings accounts                                      (275 )            (24 )          (263 )           12
Certificates of deposit                                (43 )            (27 )           (17 )            1
Repurchase agreements                                  (18 )             (5 )           (15 )            2
Long-term borrowing                                      3                0               3              0
Junior subordinated debt                                 6                0               6              0

Total interest expense                                (361 )            (31 )          (335 )            5

Net interest income                          $          78         $    338           ($254 )          ($6 )

Consolidated Average Balances, Yields and Rates

(dollars in thousands)                                              Six Month Periods Ended
                                                    June 30, 2012                              June 30, 2011
                                         Average       Interest       Yield/        Average       Interest       Yield/
                                         Balance         (1)           Rate         Balance         (1)           Rate
Assets
Interest earning assets
Federal funds sold and other
overnight investments                   $  18,732     $       22         0.24 %    $  13,795     $       15         0.22 %
Interest bearing balances with banks       15,259             15         0.20 %       16,350              9         0.11 %
Investment securities (1)                  88,161          1,088         2.47 %       93,908          1,404         3.01 %
Loans (2)                                 298,192          8,479         5.70 %      285,091          8,459         5.98 %

Total interest earning assets             420,344          9,604         4.58 %      409,144          9,887         4.87 %
Noninterest earning assets
Cash and due from banks                     7,380                                      7,785
Other assets                               14,163                                     15,663

Total Assets                            $ 441,887                                  $ 432,592

Liabilities and Stockholders' Equity
Interest bearing deposits
NOW accounts                            $  33,116     $       15         0.09 %    $  33,308     $       22         0.13 %
Money market accounts                      52,780             78         0.30 %       42,474            105         0.50 %
Savings accounts                          133,345            230         0.35 %      139,910            505         0.73 %
Certificates of deposit                    73,264            513         1.40 %       77,075            556         1.45 %
Repurchase agreements                      13,702             23         0.34 %       15,814             41         0.52 %
Long-term borrowings                       35,000            562         3.18 %       35,000            559         3.22 %
Junior subordinated debt                    5,000             93         3.68 %        5,000             87         3.51 %

Total interest bearing liabilities        346,207          1,514         0.88 %      348,581          1,875         1.08 %

Noninterest bearing Liabilities
Demand deposit accounts                    56,617                                     46,679
Other liabilities                           2,441                                      2,041
Stockholders' Equity                       36,622                                     35,291

Total Liabilities and Stockholders'
Equity                                  $ 441,887                                  $ 432,592

Interest rate spread                                                     3.71 %                                     3.79 %
Ratio of interest earning assets to
interest bearing liabilities                                           121.41 %                                   117.37 %
Net interest income and net interest
margin                                                $    8,090         3.86 %                  $    8,012         3.95 %

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

(2) Includes nonaccrual loans

Comparison of Operating Results for the Three Months Ended June 30, 2012 and 2011.

General. The Company recorded net income for the three months ended June 30, 2012 of $921,000, an increase of $595,000, compared to a net income of $326,000 for the three months ended June 30, 2011. Net income available to common shareholders was $860,000 or $0.22 per basic and $0.21 per diluted common share, compared to net income available to common shareholders of $203,000 or $0.05 per . . .