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 the Company for the past two years, although in some circumstances a period longer than two years is covered in order to comply with Securities and Exchange Commission disclosure requirements or to more fully explain long-term trends. The following discussion and analysis should be read in conjunction with the Selected Consolidated Financial Information on page 20 and the Company's Consolidated Financial Statements and related notes that appear on pages 50 through 89. All references in the discussion to the financial condition and results of operations are to the consolidated position and results of the Company and its subsidiaries taken as a whole.

Unless otherwise noted, all earnings per share ("EPS") figures disclosed in the MD&A refer to diluted EPS; interest income, net interest income and net interest margin are presented on a fully tax-equivalent ("FTE") basis. The term "this year" and equivalent terms refer to results in calendar year 2012, "last year" and equivalent terms refer to calendar year 2011, and all references to income statement results correspond to full-year activity unless otherwise noted.

This MD&A contains certain forward-looking statements with respect to the financial condition, results of operations and business of Community Bank System, Inc. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements are set herein under the caption "Forward-Looking Statements" on page 47.

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 these estimates. Management believes that the 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 recorded 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, appraisal values of underlying collateral for collateral dependent laons, 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. 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 other-than-temporary impairment 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 the 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, required equity market premiums and company-specific risk indicators, all of which are susceptible to change based on changes in economic and market 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", starting on page 55.

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 core operating objectives are: (i) grow the branch network, primarily through a disciplined acquisition strategy, and certain selective de novo expansions, (ii) build profitable loan and deposit volume using both organic and acquisition strategies, (iii) increase the non-interest income component of total revenue 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 to improve efficiencies.

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, performance of specific product lines, liquidity and interest rate sensitivity, enhancements to customer products and services, technology advancements, market share changes, peer comparisons, and the performance of acquisition and integration activities.

On April 8, 2011 the Company acquired The Wilber Corporation, 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, 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.

On July 20, 2012, Community Bank, N.A. (the" Bank"), the wholly-owned banking subsidiary of the Company, completed its acquisition of 16 retail branches in central, northern and western New York from HSBC Bank USA, N.A. ("HSBC"), acquiring approximately $106 million in loans and $697 million of deposits. The assumed deposits consist primarily of core deposits (checking, savings and money market accounts) and the purchased loans consist of in-market performing loans primarily residential real estate loans. Under the terms of the purchase agreement, the Bank paid First Niagara Bank, N.A. ("First Niagara") (who acquired HSBC's Upstate New York banking business and assigned its right to purchase the 16 branches to the Bank) a blended deposit premium of 3.4%, or approximately $24 million.

On September 7, 2012, the Bank completed its acquisition of three branches in central New York from First Niagara, acquiring approximately $54 million of loans and $101 million of deposits. The assumed deposits consist primarily of core deposits (checking, savings and money market accounts) and the purchased loans consist of in-market performing loans, primarily residential real estate loans. Under the terms of the purchase agreement, the Bank paid a blended deposit premium of 3.1%, or approximately $3 million.

In support of the HSBC and First Niagara branch acquisitions, the Company completed a public common stock offering in late January 2012 and 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 reported net income for the year ended December 31, 2012 of $77.1 million or 5.4% above 2011's reported net income of $73.1 million. Earnings per share of $1.93 for the full year 2012 were $0.08 or 4.0%, below the prior year level. The increase in net income was due to higher revenue from both increased net interest income, as a result of earning asset growth, and higher non-interest income, partially offset by a 19-basis point decrease in net interest margin. Also offsetting higher income was a higher provision for loan losses and higher operating expenses. The 2012 results included $5.7 million or $0.10 per share of acquisition expenses related to the HSBC and First Niagara branch acquisitions and a $2.5 million or $0.05 per share litigation settlement charge as compared to $4.8 million or $0.09 per share of acquisition expenses related to the Company's merger with Wilber in early April 2011. The litigation settlement charge pertains to the settlement of a class action lawsuit related to the processing of retail debit card transactions and its impact on overdraft fees. Full year 2012 earnings per share were adversely impacted by the 2.13 million shares issued in January 2012 in support of the HSBC and First Niagara branch acquisitions that closed in the third quarter of this year.

Asset quality remained favorable in 2012, with lower year-end non-performing loan ratios and loan delinquency ratios as compared to 2011. Net loan charge-off and the provision for loan loss ratios increased, but remained superior to peer company averages. The Company experienced year-over-year growth in interest-earning assets, reflective of strong organic loan growth and the HSBC and First Niagara branch acquisitions, completed in the third quarter of 2012. Average deposits increased in 2012 as compared to 2011, reflective of the HSBC and First Niagara branch acquisitions and organic growth in core deposits, offset by a reduction in time deposit balances. Average external borrowings increased from 2011 reflective of the Company's strategy of pre-investing a portion of the liquidity obtained from the HSBC and First Niagara branch acquisitions prior to their closings.

Net Income and Profitability

Net income for 2012 was $77.1 million, an increase of $3.9 million, or 5.4%, from 2011's earnings of $73.1 million. Earnings per share for 2012 were $1.93, down 4.0% from 2011's earnings per share of $2.01. The 2012 results included $5.7 million, or $0.10 per share, of acquisition expenses related principally to the Company's acquisition of the HSBC and First Niagara branch acquisitions, which were completed in the third quarter of 2012, as well as a $2.5 million or $0.05 per share litigation settlement charge. The 2011 results included $4.8 million, or $0.09 per share of acquisition expenses, principally related to the Wilber acquisition which was completed in the second quarter of 2011. Fully diluted shares outstanding increased 9.5% in 2012 over 2011, due principally to the full-year impact of the Wilber acquisition completed in early 2011 and the additional shares issued in early 2012 in support of the HSBC and First Niagara branch acquisitions.

Net income for 2011 was $73.1 million, up $9.8 million or 16% from 2010's earnings of $63.3 million. Earnings per share for 2011 were $2.01, up 6.3% from 2010's earnings per share. The 2011 results included $4.8 million, or $0.09 per share of acquisition expenses principally related to the Wilber acquisition. The 2010 results included $1.4 million or $0.03 per share of acquisition expenses, associated with the Wilber acquisition and a contract termination charge related to the core banking system conversion.

Table 1: Condensed Income Statements

                                           Years Ended December 31,
       (000's omitted, except
       per share data)             2012     2011     2010     2009     2008
       Net interest income       $230,424 $209,413 $181,684 $165,500 $148,507
       Loan loss provision          9,108    4,736    7,205    9,790    6,730
       Noninterest income          99,246   89,222   88,792   83,535   73,474
       Acquisition expenses,
       litigation settlement,
       and contract termination
       charges                      8,247    4,831    1,365    1,621    1,399
       Other noninterest
       expenses                   203,510  185,541  175,521  184,557  157,163
       Income before taxes        108,805  103,527   86,385   53,067   56,689
       Income taxes                31,737   30,385   23,065   11,622   10,749
       Net income                 $77,068  $73,142  $63,320  $41,445  $45,940

       Diluted earnings per
       share                        $1.93    $2.01    $1.89    $1.26    $1.49

The primary factors explaining 2012 earnings performance are discussed in detail in the remaining sections of this document and are summarized as follows:

· As shown in Table 1 above, net interest income increased $21.0 million, or 10.0%, due to a $848.9 million increase in average earning assets partially offset by a 19-basis point decrease in the net interest margin. Average loans grew $272.7 million due to the HSBC and First Niagara branch acquisitions and strong growth in the consumer mortgage portfolio, aided by long-term interest rates remaining low, and growth in the indirect consumer installment portfolio. The average book value of investments, including cash equivalents, increased $576.2 million or 27% in 2012 due to the net liquidity acquired from the HSBC and First Niagara branch acquisitions and organic deposit growth. Average interest-bearing deposits increased $490.7 million or 13% due to the HSBC and First Niagara branch acquisitions and organic growth. Average borrowings increased $114.4 million or 14% as compared to the prior year, as the Company pre-invested during the first half of the year a portion of the pending net liquidity received from the branch acquisitions in the third quarter.

· The loan loss provision of $9.1 million increased $4.4 million or 92%, from the prior year level and included $0.5 million for certain loans acquired in the HSBC and First Niagara branch acquisitions where the fair value exceeded the estimated net recoverable value. Net charge-offs of $8.4 million increased by $3.4 million from 2011, increasing the net charge-off ratio (net charge-offs / total average loans) eight basis points to 0.23% for the year. Nonperforming loans as a percentage of total loans and nonperforming assets as a percentage of loans and other real estate owned, decreased ten basis points and 5 basis points, respectively, in the fourth quarter as compared to the fourth quarter of the prior year and remain well below averages for the Company's peers. Additional information on trends and policy related to asset quality is provided in the asset quality section on pages 37 through 41.

· Noninterest income for 2012 of $99.2 million increased by $10.0 million, or 11%, from 2011's level due to growth in financial services revenue and fees from banking services, primarily as the result of the Wilber, CAI, HSBC and First Niagara acquisitions. Fees from banking services were $4.0 million or 8.9%, higher primarily due to higher debit card related revenue and the banking acquisitions completed over the last two years. Partially offsetting this growth was a $0.9 million decrease in mortgage banking revenue. Financial services revenue was up $6.5 million, or 15%, due to the CAI acquisition and solid organic growth in almost all lines of business.

· Total noninterest expenses, including acquisition expenses, litigation settlement, and contract termination charges increased $21.4 million, or 11.2%, in 2012 to $211.8 million, primarily due to the additional operating costs associated with the HSBC, First Niagara, Wilber and CAI acquisitions, partially offset by lower FDIC insurance. Excluding acquisition, expenses, litigation settlement, and contract termination charges, other noninterest expenses increased $18.0 million or 9.7%.

· The Company's combined effective federal and state income tax rate decreased slightly in 2012 to 29.2% as compared to 29.4% in 2011, reflective of similar levels of proportional income from both fully taxable and non-taxable sources.

Selected Profitability and Other Measures

Return on average assets, return on average equity, dividend payout and equity
to asset ratios for the years indicated are as follows:

                            Table 2: Selected Ratios

                                                 2012   2011   2010
               Return on average assets          1.08%  1.18%  1.16%
               Return on average equity          8.82% 10.36% 10.66%
               Dividend payout ratio             54.3%  49.3%  49.2%

As displayed in Table 2 above, both the return on average assets and the return on average equity decreased in 2012 as compared to 2011 and 2010. The decrease in comparison to both years was a result of net income growing at a slower pace than average assets and average equity, both of which grew significantly as a result of acquisitions, capital raised to support the transactions, organic growth, higher retained earnings and a significant increase in the unrealized gains on available-for-sale investment securities. The corresponding net income was negatively impacted by a declining net interest margin and non-recurring costs associated with the acquisitions and the litigation settlement charge in 2012. The increase in return on average assets in 2011 as compared to 2010 was a result of net income growing at a faster pace than average assets due to increasing net interest margins, non-interest income growth, lower provision for loan losses and operating expense containment. The return on equity decline in 2011 despite strong earnings growth was due to the equity issued in conjunction with the Wilber acquisition, build up of capital through earnings retention and an increase in the equity components of the investment market value adjustment due mostly to a decrease in intermediate and to long-term interest rates.

The five percentage point increase in the dividend payout ratio in 2012 as compared to 2011 was the result of a 16% increase in dividends declared while net income increased at a slower 5.4% pace. The increase in the dividends declared was a result of a 6.0% increase in the dividends declared per share as well as the additional 2.1 million shares issued in conjunction with the public stock offering in January 2012 and the 3.4 million shares issued in conjunction with the Wilber acquisition in the second quarter of 2011. The dividend payout ratio for 2011 increased slightly from 2010 as dividends declared increased 15.7% primarily as a result of a 6.4% increase in the dividends declared per share as well as the additional 3.4 million shares issued in conjunction with the Wilber acquisition in the second quarter of 2011, while net income increased a slightly smaller 15.5% from 2010.

Net Interest Income

Net interest income is the amount that interest and fees on earning assets (loans and investments) exceeds the cost of funds, which consists primarily of 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 disclosed in Table 3, net interest income (with nontaxable income converted to a fully tax-equivalent basis) totaled $247.3 million in 2012, up $22.2 million, or 9.9%, from the prior year. An $848.9 million increase in average interest-earning assets more than offset a $605.1 million increase in average interest-bearing liabilities and a 19-basis point decrease in the net interest margin. As reflected in Table 4, the volume changes increased net interest income by approximately $33.3 million, while the lower net interest margin had an $11.1 million unfavorable impact.

The net interest margin decreased 19 basis points from 4.07% in 2011 to 3.88% in 2012. This decrease was attributable a 51-basis point decrease in the earning-asset yields having a great impact than a 37-basis point decrease in the cost of interest-bearing liabilities. The yield on loans decreased 44 basis points in 2012 to 5.34% in 2012 from 5.78% in 2011, due to new volume coming on at lower yields in the current low-rate environment than the loans maturing or being prepaid, as well as variable and adjustable rate loans repricing downward. The yield on investments, including cash equivalents, decreased from 4.27% in 2011 to 3.80% in 2012, largely a result of the purchase of $899 million of U.S. Treasury, obligations of state and political subdivisions and other securities with an average yield of 2.7%. The cost of funding, including the impact of non-interest checking deposits, decreased 31 basis points during 2012 to 0.83% as compared to 1.14% for 2011. The decreased cost of funds was reflective of disciplined deposit pricing, whereby interest rates on essentially all deposit account categories were lowered throughout 2011 and 2012 in response to market conditions. Additionally, the proportion of customer deposits in higher cost time deposits declined 5.3 percentage points2012, while the percentage of deposits in non-interest bearing and lower cost checking accounts correspondingly increased.

The net interest margin in 2011 was 4.07%, compared to 4.04% in 2010. This three-basis point increase was primarily attributable to a 29-basis point decrease in interest-bearing liability yields having a greater impact than a 22-basis point decrease in earning-asset yields. The decreased cost of funds was reflective of disciplined deposit pricing, whereby interest rates on selected categories of deposit accounts were lowered throughout 2010 and 2011 in response to market conditions. The yield on loans decreased five basis points in 2011, mostly as a result of the low interest rate environment. The yield on investments, including cash equivalents, decreased from 4.70% in 2010 to 4.27% in 2011, with some of the yield decline being mitigated by the effective deployment of cash into higher yielding securities during 2011.

. . .