Overview

The following discussion is provided for the consolidated operations of the Company and its Banks. The purpose of this discussion is to focus on significant factors affecting the Company's financial condition and results of operations.

The Company does not engage in any material business activities apart from its ownership of the Banks and the managing of its own bond, equity and loan portfolios. Products and services offered by the Banks are for commercial and consumer purposes, including loans, deposits and trust services. The Banks also offer investment services through a third-party broker-dealer. The Company employs eleven individuals to assist with financial reporting, human resources, marketing, audit, compliance, technology systems and the coordination of management activities, in addition to 198 full-time equivalent individuals employed by the Banks.

The Company's primary competitive strategy is to utilize seasoned and competent Bank management and local decision-making authority to provide customers with prompt response times and flexibility in the products and services offered. This strategy is viewed as providing an opportunity to increase revenues through the creation of a competitive advantage over other financial institutions. The Company also strives to remain operationally efficient to improve profitability while enabling the Banks to offer more competitive loan and deposit rates.

The principal sources of Company revenues and cash flows are: (i) interest and fees earned on loans made by the Company and Banks; (ii) interest on fixed income investments held by the Company and the Banks; (iii) fees on trust services provided by those Banks exercising trust powers; (iv) service charges on deposit accounts maintained at the Banks; (v) gain on the sale of loans held for sale; (vi) securities gains; and (vii) merchant and card fees. The Company's principal expenses are: (i) interest expense on deposit accounts and other borrowings; (ii) salaries and employee benefits; (iii) data processing costs associated with maintaining the Banks' loan and deposit functions; (iv) occupancy expenses for maintaining the Banks' facilities; (vi) professional fees; (vi) business development; and (vii) FDIC insurance assessments. The largest component contributing to the Company's net income is net interest income, which is the difference between interest earned on earning assets (primarily loans and investments) and interest paid on interest bearing liabilities (primarily deposit accounts and other borrowings). One of management's principal functions is to manage the spread between interest earned on earning assets and interest paid on interest bearing liabilities in an effort to maximize net interest income while maintaining an appropriate level of interest rate risk.

The Company reported net income of $14,182,000 for the year ended December 31, 2012 compared to $13,921,000 and $12,966,000 reported for the years ended December 31, 2011 and 2010, respectively. This represents an increase in net income of 1.9% when comparing 2012 with 2011. The increase in net income in 2012 from 2011 was primarily the result of improved net interest income, lower provision for loan losses and a higher gain on sale of loans held for sale, offset in part by higher salaries and benefits and other noninterest expense. The Acquisition, described in Item 1 of this Report, contributed to increases in net interest income, noninterest income and noninterest expense. The increase in net income in 2011 from 2010 was primarily the result of improved net interest income and lower FDIC insurance assessment, offset in part by higher salaries and benefits and other real estate owned costs. Earnings per share for 2012 were $1.52 compared to $1.48 in 2011 and $1.37 in 2010. All five Banks demonstrated profitable operations during 2012.

The Company's return on average equity for 2012 was 10.08% compared to 10.82% and 10.91% in 2011 and 2010, respectively, and the return on average assets for 2012 was 1.24% compared to 1.38% in 2011 and 1.40% in 2010. The decrease in return on average equity and assets when comparing 2012 to 2011 was primarily a result of increased average assets and equity. The decrease in return on average equity and assets when comparing 2011 to 2010 was primarily a result of increased average assets and equity.

The following discussion will provide a summary review of important items relating to:

Challenges

Management has identified certain events or circumstances that may negatively impact the Company's financial condition and results of operations in the future and is attempting to position the Company to best respond to those challenges.

? If interest rates increase significantly over a relatively short period of time due to improving national employment or higher inflationary numbers, the interest rate environment may present a challenge to the Company. Increases in interest rates may negatively impact the Company's net interest margin if interest expense increases more quickly than interest income. The Company's earning assets (primarily its loan and investment portfolio) have longer maturities than its interest bearing liabilities (primarily deposits and other borrowings); therefore, in a rising interest rate environment, interest expense may increase more quickly than interest income as the interest bearing liabilities reprice more quickly than earning assets. In response to this challenge, the Banks model quarterly the changes in income that would result from various changes in interest rates. Management believes Bank earning assets have the appropriate maturity and repricing characteristics to optimize earnings and the Banks' interest rate risk positions.

? If market interest rates in the three to five year levels remain at historically low levels as compared to the short term interest rates, the interest rate environment may present a challenge to the Company. The Company's earning assets (typically priced at market interest rates in the three to five year range) will reprice at lower interest rates, but the deposits will not reprice at significantly lower interest rates, therefore the net interest income may decrease. Management believes Bank earning assets have the appropriate maturity and repricing characteristics to optimize earnings and the Banks' interest rate risk positions.

? Other real estate owned amounted to $9.9 million and $9.5 million as of December 31, 2012 and 2011, respectively. Other real estate owned costs amounted to $483,000, $434,000 and $95,000 for the years ended December 31, 2012, 2011 and 2010, respectively. Management obtains independent appraisals or performs evaluations to determine that these properties are carried at the lower of the new cost basis or fair value less cost to sell. It is at least reasonably possible that change in fair values will occur in the near term and that such changes could have a negative impact on the Company's earnings.

? The full compliance burden and impact on the Company's operations and profitability with respect to the Dodd-Frank Act are currently unknown, as the Dodd-Frank Act delegates to various federal agencies the task of implementing its many provisions through regulation. Hundreds of new federal regulations, studies and reports are required under the Dodd-Frank Act and not all of them have been finalized. Although certain provisions of the Dodd-Frank Act have been implemented, federal rules and policies in this area will be further developing for months and years to come. Based on the provisions of the Dodd-Frank Act and anticipated implementing regulations, it is highly likely that the Banks, as well as the Company, will be subject to significantly increased regulation and compliance obligations that will expose the Company to higher costs as well as noncompliance risk and consequences.

? The Consumer Financial Protection Bureau, established under the Dodd-Frank Act, has broad rulemaking authority to administer and carry out the purposes and objectives of the "Federal consumer financial laws, and to prevent evasions thereof" with respect to all financial institutions that offer financial products and services to consumers. The Bureau is also authorized to prescribe rules, applicable to any covered person or service provider, identifying and prohibiting acts or practices that are "unfair, deceptive, or abusive" in connection with any transaction with a consumer for a consumer financial product or service, or the offering of a consumer financial product or service ("UDAAP authority"). The term "abusive" is new and untested, and because Bureau officials have indicated that compliance will be achieved through enforcement rather than the issuance of regulations, the Company cannot predict to what extent the Bureau's future actions will have on the banking industry or the Company. The full reach and impact of the Bureau's broad new rulemaking powers and UDAAP authority on the operations of financial institutions offering consumer financial products or services is currently unknown. Notwithstanding the foregoing, insured depository institutions with assets of $10 billion or less (such as the Banks) will continue to be supervised and examined by their primary federal regulators, rather than the Bureau, with respect to compliance with federal consumer protection laws. To date, the Bureau has finalized a number of regulations affecting non-bank entities that offer consumer financial products and services, including those related to "larger participants" (over which the Bureau will have supervisory authority). In addition, with respect to all entities subject to Bureau enforcement activity, the Bureau has issued final rules with respect to the confidential treatment of privileged information and rules of practice for adjudicatory proceedings.

Key Performance Indicators

Certain key performance indicators for the Company and the industry are presented in the following chart. The industry figures are compiled by the Federal Deposit Insurance Corporation (FDIC) and are derived from 7,083 commercial banks and savings institutions insured by the FDIC. Management reviews these indicators on a quarterly basis for purposes of comparing the Company's performance from quarter to quarter against the industry as a whole.

Selected Indicators for the Company and the Industry

                                                  Year Ended December 31,
                               2012                        2011                        2010
                      Company       Industry      Company       Industry      Company       Industry

Return on assets          1.24 %         1.00 %       1.38 %         0.88 %       1.40 %         0.66 %

Return on equity         10.08 %         8.92 %      10.82 %         7.86 %      10.91 %         5.99 %

Net interest margin       3.35 %         3.42 %       3.60 %         3.60 %       3.74 %         3.76 %

Efficiency ratio         52.33 %        61.60 %      49.80 %        61.37 %      50.12 %        57.22 %

Capital ratio            12.31 %         9.15 %      12.75 %         9.09 %      12.80 %         8.90 %

Key performance indicators include:

This ratio is calculated by dividing net income by average assets. It is used to measure how effectively the assets of the Company are being utilized in generating income. The Company's return on assets ratio is higher than that of the industry, primarily as a result of the Company's lower provision for loan losses and non-interest expense relative to the industry.

This ratio is calculated by dividing net income by average equity. It is used to measure the net income or return the Company generated for the shareholders' equity investment in the Company. The Company's return on equity ratio is higher than the industry primarily as a result of the Company's lower provision for loan losses and non-interest expense relative to the industry, offset in part by a higher capital ratio.

This ratio is calculated by dividing net interest income by average earning assets. Earning assets consist primarily of loans and investments that earn interest. This ratio is used to measure how well the Company is able to maintain interest rates on earning assets above those of interest-bearing liabilities, which is the interest expense paid on deposit accounts and other borrowings. The Company's net interest margin is comparable to that of the industry.

This ratio is calculated by dividing noninterest expense by net interest income and noninterest income. The ratio is a measure of the Company's ability to manage noninterest expenses. The Company's efficiency ratio is lower than the industry average. The Company's efficiency ratio is lower than the industry primarily as a result of the Company's lower non-interest expense.

The capital ratio is calculated by dividing average total equity capital by average total assets. It measures the level of average assets that are funded by shareholders' equity. Given an equal level of risk in the financial condition of two companies, the higher the capital ratio, generally the more financially sound the company. The Company's capital ratio is significantly higher than the industry average.

Industry Results

The FDIC Quarterly Banking Profile reported the following results for the fourth quarter of 2012:

Net Income Is More Than a Third Higher Than in Fourth Quarter 2011

Bolstered by higher noninterest income and lower provisions for loan losses, earnings at FDIC-insured institutions in fourth quarter 2012 posted a $9.3 billion (36.9%) increase over the total for fourth quarter 2011. The $34.7 billion in fourth-quarter net income was the highest total for a fourth quarter since 2006. Well over half of all institutions-60%-reported year-over-year improvement in quarterly earnings, while the share of institutions reporting net losses for the quarter fell to 14%, from 20% a year earlier. The average return on assets (ROA) rose to 0.97% from 0.73% in fourth quarter 2011.

Noninterest Income Rebounds From Year-Earlier Weakness

The $10 billion (18.2%) year-over-year improvement in noninterest income was driven primarily by higher gains on loan sales (up $2.4 billion, or 132.4%, over fourth quarter 2011), increased trading revenue (up $1.9 billion, or 75.3%), and reduced losses on sales of foreclosed property (down $1.2 billion, or 72%). Additionally, noninterest income at some large banks was adversely affected a year ago by appreciation in the fair values of their liabilities; the absence of similar accounting losses in this quarter's results also helped to improve noninterest income. Overall, almost two out of every three banks (62.3%) reported year-over-year increases in noninterest income.

Insured Institutions Continue to Reduce Their Loss Provisions

Banks set aside $15.1 billion in loan-loss provisions in the fourth quarter, a $4.9 billion (24.6%) reduction compared with fourth quarter 2011. This is the smallest fourth-quarter loss provision since 2006, and marks the 13th consecutive quarter with a year-over-year decline in loss provisions. More than half of all institutions-53.6%-reported lower loss provisions.

Banks See Margins Erode

The increase in noninterest income and reduction in loss provisions helped offset a $2.7 billion (2.5%) year-over-year decline in net interest income. Fourth-quarter net interest income totaled $104.4 billion, compared with $107.1 billion a year ago. This is the lowest quarterly total since fourth quarter 2009, when the industry had $1.4 trillion less in interest-bearing assets. The average net interest margin (NIM) fell to 3.32%, from 3.57% in fourth quarter 2011, as average asset yields declined more rapidly than average funding costs. This is the lowest quarterly NIM for the industry since fourth quarter 2007. More than two-thirds of all banks-67.9%-reported year-over-year NIM declines.

Full-Year Earnings Are Second Highest Ever

Full-year net income totaled $141.3 billion, a $22.9 billion (19.3%) improvement over 2011. This is the second-highest annual earnings ever reported by the industry, after the $145.2 billion total in 2006, when the industry had $2.7 trillion less in assets. The average ROA rose to 1.00% from 0.88% in 2011. The largest contribution to the increase in earnings came from reduced provisions for loan losses, which fell by $19.3 billion (24.9%). Noninterest income was $18.4 billion (8%) higher than in 2011, thanks to an $11.2 billion (174.4%) increase in gains on loan sales, a $6.8 billion (93.9%) increase in servicing income, and a $2.4 billion (51.8%) reduction in losses on foreclosed property sales. The improvement in noninterest income was limited by a $12.4 billion negative swing in results from trading credit exposures. Net interest income was $1.3 billion (0.3%) lower than in 2011, as the full-year NIM fell from 3.60% to 3.42%. Realized gains on securities and other assets added $4.2 billion (75.7%) more to pretax earnings than a year earlier.

Loan Losses Improve Across All Loan Categories

Asset quality indicators continued to improve in the fourth quarter. Net charge-offs (NCOs) totaled $18.6 billion, down $7 billion (27.4%) from fourth quarter 2011. This is the 10th consecutive quarter that NCOs have declined. It is the lowest quarterly NCO total since fourth quarter 2007. All major loan categories showed year-over-year improvement in quarterly NCO amounts. The largest declines occurred in 1-to-4 family residential mortgages, where quarterly NCOs fell by $1.5 billion (29.3%), in real estate construction and development loans, where NCOs declined by $1.3 billion (62.6%), in credit cards, where NCOs were $1 billion (14.1%) lower, and in loans to commercial and industrial (C&I) borrowers, where NCOs were also $1 billion (39.7%) lower.

Noncurrent Rate Declines to Four-Year Low

The amount of loans that were noncurrent (90 days or more past due or in nonaccrual status) declined by $16.1 billion (5.5%) during the quarter. At year-end, noncurrent loan balances totaled $276.8 billion, compared with $292.8 billion at the end of the third quarter. The percentage of total loans and leases that were noncurrent fell from 3.86% to 3.60%, the lowest level since the end of 2008. Noncurrent balances fell in all major loan categories in the fourth quarter. Noncurrent 1-to-4 family residential mortgage balances declined by $6.4 billion (3.5%), while noncurrent real estate construction and development loans fell by $3.6 billion (17.3%), and noncurrent nonfarm nonresidential real estate loans declined by $3.1 billion (9.2%).

Coverage of Noncurrent Loans Improves Despite Reduction in Reserves

Insured institutions reduced their reserves for loan losses by $5 billion (3%) in the fourth quarter, as fourth-quarter loss provisions replenished only $15.1 billion of the $18.6 billion taken out of reserves by NCOs. This is the 11th consecutive quarter that the industry's reserve balances have declined. The trend toward lower reserves continues to be led by larger institutions. More institutions added to their reserves than reduced them (48.8% versus 43.5%, respectively). Despite the overall reduction in reserves, the larger decline in noncurrent loan balances at insured institutions meant that the industry's coverage ratio of reserves to noncurrent loans increased from 57.0% to 58.5% during the quarter.

Decline in Securities Values Contributes to Reduction in Equity Capital

Total equity capital fell by $5.6 billion (0.3%) in the fourth quarter. The decline reflected a $7.2 billion decrease in accumulated other comprehensive income, as unrealized gains on securities held for sale fell by $7.6 billion (10.4%). For the industry as a whole, retained earnings made no contribution to equity formation in the fourth quarter, as declared dividends of $35.5 billion exceeded the $34.7 billion in quarterly net income. The high level of dividends was the result of a large quarterly dividend declared at one institution. A majority of institutions, 55.2%, added to their equity capital during the quarter.

Loan Balances Increase for Sixth Time in Seven Quarters

Total assets increased by $227.8 billion (1.6%). Loans accounted for more than half of the increase, as net loan and lease balances rose by $123.2 billion (1.7%). Loan growth was led by C&I loans (up $53.4 billion, or 3.7%), credit cards (up $28.2 billion, or 4.2%), and nonfarm nonresidential real estate loans (up $14.6 billion, or 1.4%). Home equity loan balances fell by $12.6 billion (2.2%) during the quarter, while balances of real estate construction and development loans declined by $6.6 billion (3.1%). Loans to small businesses and farms increased by $1.7 billion (0.3%), as small C&I loans (original amounts of $1 million or less) rose by $5.3 billion (1.9%), and small farmland loans (original amounts of $500,000 or less) increased by $234 million (0.6%). Cash and balances due from depository institutions increased by $87.2 billion (6.4%), as banks increased their balances with Federal Reserve banks by $60.2 billion
(9.1%). Banks' investment securities portfolios grew by $23.5 billion (0.8%)
during the quarter.

Large Denomination Deposit Balances Surge

Total deposits increased by $313.1 billion (3%), as deposits in domestic offices posted a record $386.8 billion (4.3%) increase. Most of the growth consisted of large denomination deposits. Balances in accounts of more than $250,000 increased by $348.5 billion (8.2%). Uninsured deposit balances increased by $252.7 billion (12.7%), while balances in noninterest-bearing transaction accounts above the basic FDIC coverage level of $250,000 that had temporary full FDIC coverage through the end of 2012 increased by $49.5 billion (3.3%). Banks reduced their nondeposit liabilities by $76.9 billion (3.7%), and their foreign office deposits by $73.7 billion (5.1%).

Quarterly Failures Decline to 4 ½ Year Low

In the fourth quarter, the number of insured commercial banks and savings institutions reporting financial results fell from 7,181 to 7,083. During the quarter, 88 institutions were merged into other banks, and eight insured institutions failed. This is the smallest number of failures in a quarter since second quarter 2008. For the sixth quarter in a row, no new reporting institutions were added. The year 2012 is the first in FDIC history that no new reporting institutions were added, and the second year in a row with no start-up de novo charters (the three new reporters in 2011 were all charters created to absorb failed banks). The number of institutions on the FDIC's "Problem List" declined for a seventh consecutive quarter, from 694 to 651. Total assets of "problem" institutions fell from $262 billion to $233 billion. During the fourth quarter, insured institutions increased the number of their employees by 4,259 (0.2%).

Critical Accounting Policies

The discussion contained in this Item 7 and other disclosures included within this Annual Report are based on the Company's audited consolidated financial statements. These statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained in these statements is, for the most part, based on the financial effects of transactions and events that have already occurred. However, the preparation of these statements requires management to make certain estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses.

The Company's significant accounting policies are described in the "Notes to Consolidated Financial Statements" accompanying the Company's audited financial statements. Based on its consideration of accounting policies that involve the most complex and subjective estimates and judgments, management has identified the allowance for loan losses, valuation of other real estate owned, the assessment of other-than-temporary impairment for certain financial instruments and the assessment of goodwill and intangible assets to be the Company's most critical accounting policies.

Allowance for Loan Losses

The allowance for loan losses is established through a provision for loan losses that is treated as an expense and charged against earnings. Loans are charged against the allowance for loan losses when management believes that collectability of the principal is unlikely. The Company has policies and procedures for evaluating the overall credit quality of its loan portfolio, including timely identification of potential problem loans. On a quarterly basis, management reviews the appropriate level for the allowance for loan losses, incorporating a variety of risk considerations, both quantitative and qualitative. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, known information about individual loans and other factors. Qualitative factors include the general economic environment in the Company's market area. To the extent actual results differ from forecasts and management's judgment, the allowance for loan losses may be greater or lesser than future charge-offs. Due to potential changes in conditions, it is at least reasonably possible that changes in estimates will occur in the near term and that such changes could be material to the amounts reported in the Company's financial statements.

For further discussion concerning the allowance for loan losses and the process of establishing specific reserves, see the section of this Annual Report entitled "Asset Quality Review and Credit Risk Management" and "Analysis of the Allowance for Loan Losses".

Other Real Estate Owned

Real estate properties acquired through or in lieu of foreclosure are initially recorded at the fair value less estimated selling cost at the date of foreclosure. Any write-downs based on the asset's fair value at the date of acquisition are charged to the allowance for loan losses. Costs of significant property improvements are capitalized, whereas costs relating to holding property are expensed. The portion of interest costs relating to development of real estate is capitalized. Valuations are periodically performed by management and property held for sale is carried at the lower of the new cost basis or fair value less cost to sell and any subsequent write-downs are charged to operations. Impairment losses on property to be held and used are measured as . . .