United States

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.   20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2012

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________  to __________

Commission File Number 000 - 19300

NORTHERN STATES FINANCIAL CORPORATION

(Exact name of Registrant as specified in its charter)

Delaware	36-3449727
(State of Incorporation)	(I.R.S. Employer Identification No.)

1601 North Lewis Avenue

Waukegan, Illinois  60085

(847) 244-6000

(Address, including zip code, and telephone number, including area code, of principal executive office)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90days.        YES: x             NO:o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).        YES: x          NO: o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer o	Accelerated Filer o	Non-accelerated Filer o	Smaller reporting company x
(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).        YES: o          NO: x

4,270,755 shares of common stock were outstanding at November 2, 2012

NORTHERN STATES FINANCIAL CORPORATION AND SUBSIDIARY

FORM 10-Q

For the Quarter Ended September 30, 2012

INDEX

PART I.   FINANCIAL INFORMATION
Item 1.	Financial Statements	Page Number
	Report of Independent Registered Public Accounting Firm	2
	Condensed Consolidated Financial Statements and Notes	3
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	32
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	49
Item 4.	Controls and Procedures	50
PART II.   OTHER INFORMATION
Item 1.	Legal Proceedings	51
Item 1A.	Risk Factors	51
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	51
Item 3.	Defaults Upon Senior Securities	51
Item 4.	Mine Safety Disclosures	51
Item 5.	Other Information	51
Item 6.	Exhibits	51
Signatures		53
EXHIBIT INDEX		54

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders

Northern States Financial Corporation

Waukegan, Illinois

We have reviewed the accompanying interim condensed consolidated balance sheet of NORTHERN STATES FINANCIAL CORPORATION as of September 30, 2012, the condensed consolidated statements of operations and consolidated statements of comprehensive operations for the three and nine month periods ended September 30, 2012 and 2011 and the condensed consolidated statements of cash flows and stockholders equity for the nine month periods ended September 30, 2012 and 2011.  These interim financial statements are the responsibility of the company's management.

We conducted our review in accordance with standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the accompanying interim condensed financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

  /s/  Plante & Moran, PLLC

Chicago, Illinois

November 6, 2012

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NORTHERN STATES FINANCIAL CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

September 30, 2012 and December 31, 2011	September 30,			December 31,
(In thousands of dollars) (Unaudited)	2012			2011
Assets
Cash and due from banks	$	4,555		$	5,313
Interest bearing deposits in financial institutions -maturities less than 90 days		36,657			32,520
Total cash and cash equivalents		41,212			37,833
Interest bearing deposits in financial institutions -maturities of 90 days or greater		2,976			0
Securities available for sale		81,552			87,140
Loans and leases, net of deferred fees		283,756			322,713
Less: Allowance for loan and lease losses		(16,559	)		(18,984	)
Loans and leases, net		267,197			303,729
Federal Home Loan Bank stock		931			1,801
Office buildings and equipment, net		8,697			9,069
Other real estate owned		12,792			19,342
Accrued interest receivable		1,191			1,401
Other assets		2,816			2,675
Total assets	$	419,364		$	462,990
Liabilities and Stockholders' Equity
Liabilities
Deposits
Demand - noninterest bearing	$	66,699		$	67,955
Interest bearing		293,274			329,676
Total deposits		359,973			397,631
Securities sold under repurchase agreements		19,726			19,455
Subordinated debentures		10,310			10,310
Advances from borrowers for taxes and insurance		552			1,222
Accrued interest payable and other liabilities		7,435			5,833
Total liabilities		397,996			434,451
Stockholders' Equity
Common stock (Par value $0.40 per share, authorized 6,500,000 shares, issued 4,472,255 at September 30, 2012 and December 31, 2011. Shares outstanding of 4,270,755 at September 30, 2012 and 4,277,755 at December 31, 2011)		1,789			1,789
Preferred stock (Par value $0.40 per share, authorized 1,000,000 shares, issued 17,211 shares with liquidation amounts of $1,000.00 per share at September 30, 2012 and December 31, 2011)		17,011			16,904
Warrants (584,084 issued and outstanding at September 30, 2012 and December 31, 2011)		681			681
Additional paid-in capital		7,297			7,054
(Accumulated deficit) retained earnings		(2,794	)		5,489
Treasury stock, at cost (201,500 shares at September 30, 2012 and 194,500 shares at December 31, 2011)		(4,674	)		(4,512	)
Accumulated other comprehensive income, net		2,058			1,134
Total stockholders' equity		21,368			28,539
Total liabilities and stockholders' equity	$	419,364		$	462,990

The accompanying notes are an integral part of these condensed consolidated financial statements.

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NORTHERN STATES FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Three and nine months ended September 30, 2012 and 2011

(In thousands of dollars, except per share data) (Unaudited)	Three months ended						Nine months ended
	September 30,			September 30,			September 30,			September 30,
	2012			2011			2012			2011
Interest income
Loans (including fee income)	$	3,502		$	4,492		$	11,494		$	14,021
Securities
Taxable		483			523			1,477			1,632
Exempt from federal income tax		30			36			91			109
Federal funds sold and other		28			13			65			47
Total interest income		4,043			5,064			13,127			15,809
Interest expense
Time deposits		138			370			503			1,463
Other deposits		25			80			143			250
Repurchase agreements and federal funds purchased		0			13			9			65
Subordinated debentures		64			58			193			172
Total interest expense		227			521			848			1,950
Net interest income		3,816			4,543			12,279			13,859
Provision for loan and lease losses		2,100			2,000			6,100			5,700
Net interest income after provision for loan and lease losses		1,716			2,543			6,179			8,159
Noninterest income
Service fees on deposits		428			457			1,244			1,298
Trust income		110			154			427			550
Gain on sale of securities		0			135			0			277
Net gain (loss) on sale of other real estate owned		50			14			(194	)		12
Net loss on sale of other assets		0			0			0			(38	)
Other than temporary impairment of securities		0			0			0			(143	)
Noncredit portion of other than temporary impairment of securities		0			0			0			(20	)
Other operating income		367			343			1,203			1,018
Total noninterest income		955			1,103			2,680			2,954
Noninterest expense
Salaries and employee benefits		1,498			1,718			4,896			5,217
Occupancy and equipment, net.		545			597			1,638			1,853
Data processing		487			472			1,670			1,446
Legal		173			179			548			666
FDIC insurance		241			228			721			930
Audit and other professional		270			208			850			835
Printing and supplies expense		54			54			185			201
Write-down of other real estate owned		1,160			797			3,855			2,125
Other real estate owned expense		(123	)		525			315			829
Loan and collection		17			90			268			822
Other operating expenses		418			464			1,353			1,259
Total noninterest expense		4,740			5,332			16,299			16,183
Loss before income taxes.		(2,069	)		(1,686	)		(7,440	)		(5,070	)
Income tax expense		0			0			0			0
Net loss		(2,069	)		(1,686	)		(7,440	)		(5,070	)
Dividends to preferred stockholders		248			236			736			699
Accretion of discount on preferred stock		36			33			107			102
Net loss available to common stockholders	$	(2,353	)	$	(1,955	)	$	(8,283	)	$	(5,871	)
Basic loss per share	$	(0.55	)	$	(0.46	)	$	(1.94	)	$	(1.37	)
Diluted loss per share	$	(0.55	)	$	(0.46	)	$	(1.94	)	$	(1.37	)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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NORTHERN STATES FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS

Three and nine months ended September 30, 2012 and 2011

(In thousands of dollars) (Unaudited)	Three months ended						Nine months ended
	September 30,			September 30,			September 30,			September 30,
	2012			2011			2012			2011
Net loss	$	(2,069	)	$	(1,686	)	$	(7,440	)	$	(5,070	)
Other comprehensive income:
Unrealized gains on securities available for sale, net of tax		315			1,320			924			3,013
Comprehensive loss	$	(1,754	)	$	(366	)	$	(6,516	)	$	(2,057	)

The accompanying notes are an integral part of these condensed consolidated financial statements.

NORTHERN STATES FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

Nine months ended September 30, 2012 and 2011

(In thousands of dollars) (Unaudited)										Retained						Accumulated
							Additional			Earnings						Other			Total
	Common		Preferred				Paid-In			(Accumulated			Treasury			Comprehensive			Stockholders'
	Stock		Stock		Warrants		Capital			Deficit)			Stock, at Cost			Income (Loss), Net			Equity
Balance, December 31, 2010	$	1,789	$	16,768	$	681	$	11,584		$	13,250		$	(9,280	)	$	(1,507	)	$	33,285
Net loss											(5,070	)								(5,070	)
Accrued dividend on preferred stock											(699	)								(699	)
Accretion of preferred stock discount issued				102							(102	)								0
Restricted stock awards from treasury stock								(4,791	)					4,791						0
Restricted stock awards expense								210												210
Unrealized net gain on securities available for sale																	3,013			3,013
Balance, September 30, 2011	$	1,789	$	16,870	$	681	$	7,003		$	7,379		$	(4,489	)	$	1,506		$	30,739
Balance, December 31, 2011	$	1,789	$	16,904	$	681	$	7,054		$	5,489		$	(4,512	)	$	1,134		$	28,539
Net loss											(7,440	)								(7,440	)
Accrued dividend on preferred stock											(736	)								(736	)
Accretion of preferred stock discount issued				107							(107	)								0
Restricted stock awards expense								81												81
Restricted stock awards forfeited								162						(162	)
Unrealized net gain on securities available for sale																	924			924
Balance, September 30, 2012	$	1,789	$	17,011	$	681	$	7,297		$	(2,794	)	$	(4,674	)	$	2,058		$	21,368

The accompanying notes are an integral part of these consolidated financial statements.

5

NORTHERN STATES FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Nine months ended September 30, 2012 and 2011	Nine months ended
(In thousands of dollars) (Unaudited)	September 30,			September 30,
	2012			2011
Cash flows from operating activities
Net loss	$	(7,440	)	$	(5,070	)
Adjustments to reconcile net loss to net cash from operating activities:
Depreciation		509			515
Gain on sales of securities		0			(277	)
Net impairment loss on securities		0			163
Provision for loan and lease losses		6,100			5,700
Write-down of other real estate owned		3,855			2,125
Net loss (gain) on sales of other real estate owned		194			(12	)
Restricted stock awards expense		81			210
Net change in accrued interest receivable and other assets		566			846
Net change in accrued interest payable and other liabilities		(327	)		(324	)
Net cash provided from operating activities		3,538			3,876
Cash flows from investing activities
Changes in interest bearing deposits in financial institutions -maturities of 90 days or greater		(2,976	)		0
Proceeds from maturities, calls and principal reductions of securities available for sale		7,482			6,245
Redemptions of Federal Home Loan Bank stock		870			0
Proceeds from sales of securities available for sale		0			19,852
Purchases of securities available for sale		(400	)		(19,793	)
Changes in loans made to customers		26,419			20,135
Property and equipment expenditures		(137	)		(175	)
Proceeds from sales of other real estate owned		6,640			7,998
Net cash provided from investing activities		37,898			34,262
Cash flows from financing activities
Net increase (decrease) in:
Deposits		(37,658	)		(11,444	)
Securities sold under repurchase agreements and other short-term borrowings		271			(14,830	)
Advances from borrowers for taxes and insurance		(670	)		(754	)
Net cash used in financing activities		(38,057	)		(27,028	)
Net change in cash and cash equivalents		3,379			11,110
Cash and cash equivalents at beginning of period		37,833			30,357
Cash and cash equivalents at end of period	$	41,212		$	41,467
Supplemental disclosures
Cash paid for interest	$	819		$	2,177
Noncash transfer of loans to other real estate owned		4,174			8,128
Noncash accrual of preferred dividends		736			699

The accompanying notes are an integral part of these condensed consolidated financial statements.

6

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

Note 1 - Basis of Presentation

The accompanying interim condensed consolidated financial statements are prepared without audit and reflect all adjustments which are of a normal and recurring nature and, in the opinion of management, are necessary to present interim financial statements of Northern States Financial Corporation (the "Company") in accordance with accounting principles generally accepted in the United States of America. The interim financial statements do not purport to contain all the necessary financial disclosures covered by accounting principles generally accepted in the United States of America that might otherwise be necessary for complete financial statements.

To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information.  These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ.  Estimates and assumptions used for the allowance for loan and lease losses, valuation of other real estate owned, valuation of other than temporarily impaired securities, valuation of deferred tax assets and status of contingencies are particularly subject to change.

 The interim condensed consolidated financial statements should be read in conjunction with the audited financial statements and accompanying notes (or "notes thereto") of the Company for the years ended December 31, 2011 and 2010 included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 as filed with the Securities and Exchange Commission.  The results of operations for the nine month period ended September 30, 2012 included herein are not necessarily indicative of the results to be expected for the full year 2012.

Net loss available to common stockholders was utilized to calculate loss per share for all periods presented.  During the periods presented, the Company had preferred stock and common stock equivalents from warrants related to funds received from the U.S Department of the Treasury (the “Treasury Department”) through its Capital Purchase Program.  However, common stock equivalents from warrants during the periods presented were antidilutive and, therefore, not considered in computing diluted loss per share.

7

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

(Dollars in thousands, except per share data)	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2012			2011			2012			2011
Basic loss per share:
Net loss	$	(2,069	)	$	(1,686	)	$	(7,440	)	$	(5,070	)
Dividends accrued to preferred stockholders		248			236			736			699
Accretion of discount on preferred stock		36			33			107			102
Net loss available to common stockholders	$	(2,353	)	$	(1,955	)	$	(8,283	)	$	(5,871	)
Weighted average common shares outstanding		4,274,733			4,278,755			4,276,740			4,276,154
Basic loss per share	$	(0.55	)	$	(0.46	)	$	(1.94	)	$	(1.37	)
Diluted earnings per share:
Net loss	$	(2,069	)	$	(1,686	)	$	(7,440	)	$	(5,070	)
Dividends accrued to preferred stockholders		248			236			736			699
Accretion of discount on preferred stock		36			33			107			102
Net loss available to common stockholders	$	(2,353	)	$	(1,955	)	$	(8,283	)	$	(5,871	)
Weighted average common shares outstanding		4,274,733			4,278,755			4,276,740			4,276,154
Add: Dilutive effect of common stock equivalents		0			0			0			0
Weighted average common and dilutive common shares outstanding		4,274,733			4,278,755			4,276,740			4,276,154
Diluted loss per share	$	(0.55	)	$	(0.46	)	$	(1.94	)	$	(1.37	)

Note 2 – Preferred Stock

On February 20, 2009, pursuant to the Treasury Department’s TARP Capital Purchase Program, the Company issued to the Treasury Department, in exchange for total proceeds of $17,211,000, (i) 17,211 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”), par value $.40 per share and a liquidation amount equal to $1,000 per share, and (ii) a ten-year warrant (the “Warrant”) to purchase up to 584,084 shares of the Company’s common stock, at an exercise price of $4.42 per share.  The $17,211,000 proceeds were allocated to the Series A Preferred Stock and the Warrant based on the relative fair value of the instruments.  The fair value of the preferred stock was estimated using an approximate 12% discount rate and a five-year expected life.  A fair value of $681,000 was estimated for the warrants using a Black-Sholes valuation.  The assumptions used in the Black-Sholes valuation were as follows: $4.42 strike price based on the contract, approximately 53% for the calculated volatility, 3.1% for the weighted average dividends, five years for the expected term and 2% for the risk free rate.

The difference between the initial carrying value of $16,530,000 that was allocated to the Series A Preferred Stock and its redemption value of $17,211,000 will be charged to retained earnings (with a corresponding increase to the carrying value of the Series A Preferred Stock) over the first five years as an adjustment to the dividend yield using the effective yield method.  The Series A Preferred Stock is generally non-voting and qualifies as Tier 1 capital.

8

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

In the event of a liquidation or dissolution of the Company, the Series A Preferred Stock then outstanding takes precedence over the Company’s common stock for the payment of dividends and distribution of assets.

Dividends are payable quarterly on the Series A Preferred Stock at an annual dividend rate of 5% per year for the first five years, and 9% per year thereafter.  The effective yield of the Series A Preferred Stock is approximately 5.94%.  In November 2009, the Company notified the Treasury Department of its intent to suspend its dividend payments on its Series A Preferred Stock.  The suspension of the dividend has continued through September 30, 2012.  At September 30, 2012, the accumulated dividends payable to the Treasury Department totaled $2.9 million which includes compounding on unpaid dividends at 5.00%.  The suspension of dividend payments is permissible under the terms of the TARP Capital Purchase Program, but the dividend is a cumulative dividend and failure to pay dividends for six dividend periods triggers board of director appointment rights for the holder of the Series A Preferred Stock.  At September 30, 2012, the Company had suspended twelve dividend payments and the Company expects that the Treasury Department will appoint one director in 2012.  In January 2011, the Company agreed to allow a Treasury Department representative to attend its Board of Directors meetings as an observer.

For as long as any shares of Series A Preferred Stock are outstanding, no dividends may be declared or paid on the Company’s common stock unless all accrued and unpaid dividends for all past dividend periods on the Series A Preferred Stock are fully paid. Pursuant to the Capital Purchase Program, the Treasury Department’s consent is required for any increase in dividends on the Company’s common stock above the amount of $0.40 per share, the last semi-annual common stock dividend declared by the Company prior to October 14, 2008, unless the Series A Preferred Stock is redeemed in whole or until the Treasury Department has transferred all of the Series A Preferred Stock it owns to third parties.

The Company may not repurchase any of its common stock without the prior consent of the Treasury Department for as long as the shares of Series A Preferred Stock are outstanding to the Treasury Department or until the Treasury Department transfers all of the Series A Preferred Stock it owns to third parties.

Note 3 – Common Stock

Information related to common stock at the dates indicated was as follows:

	September 30,		December 31,
	2012		2011
Par value per share	$	0.40	$	0.40
Authorized shares		6,500,000		6,500,000
Issued shares		4,472,255		4,472,255
Treasury shares		201,500		194,500
Outstanding shares		4,270,755		4,277,755

Pursuant to the Capital Purchase Program, the Company issued to the Treasury Department Warrants to purchase up to 584,084 shares of the Company’s common stock at an exercise price of $4.42 per share.  Based upon its fair value relative to the Series A Preferred Stock discussed in Note 2 above, the Warrants were recorded at a value of $681,000 and are accounted for as equity.  The Warrants are exercisable, in whole or in part, at any time, from time to time, until the tenth anniversary of the issue date.

9

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

The 2009 Restricted Stock Plan (the "Plan") authorizes the issuance of 400,000 shares of the Company's common stock to be issued in whole or in part from treasury shares or authorized and unissued shares not reserved for any other purpose. Awards under the Plan may be made to directors and employees of both the Company and its subsidiaries and may consist of restricted stock with associated voting rights and the right to receive dividends.  Awards may also be issued as stock units not having voting rights or the right to receive dividends until the terms of the award are satisfied and the shares of the Company's stock are actually issued.  The terms and conditions of each award is set forth and described in an award agreement between the Company and the participant.

In January 2011, 207,500 shares of restricted stock were issued pursuant to the 2009 Restricted Stock Plan from the Company’s treasury stock.  Since originally issued, employees have forfeited 9,000 shares of restricted stock, which were returned to treasury stock lowering the total shares issued pursuant to the Plan to 198,500 shares.  During the nine months ended September 30, 2012, 10,500 shares issued to employees vested.  A total of 108,000 restricted stock shares granted to employees of the Company will fully vest in January 2013. Of the 80,000 shares issued to directors, 70,000 shares vested during the first quarter of 2011, while the remaining 10,000 shares fully vest in January 2013.  The expense attributable to these restricted stock awards recognized during the three months ended September 30, 2012 and 2011 totaled $20,000 and $29,000, respectively. The expense attributable to these restricted stock awards recognized during the nine months ended September 30, 2012 and 2011 totaled $79,000 and $210,000, respectively.

Note 4 – Securities

At September 30, 2012 and December 31, 2011, the Company had the following securities in its investment portfolio:

			Gross Unrealized
September 30, 2012  ($000's)	Fair Value		Gain		Loss
States and political subdivisions	$	2,598	$	141	$	(8	)
Mortgage-backed securities		74,612		2,915		0
Equity securities		4,342		238		0
Total securities available for sale	$	81,552	$	3,294	$	(8	)

			Gross Unrealized
December 31, 2011  ($000's)	Fair Value		Gains		Losses
States and political subdivisions	$	3,117	$	112	$	(10	)
Mortgage-backed securities		79,762		1,533		0
Equity securities		4,261		157		0
Total securities available for sale	$	87,140	$	1,802	$	(10	)

10

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

At September 30, 2012, the Company had pledged securities of $51.1 million as compared to $57.0 million at December 31, 2011.  Securities are pledged to secure public deposits, repurchase agreements and for other purposes as required or permitted by law.

Contractual maturities of securities available for sale at September 30, 2012 are set forth below. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately:

	Fair
September 30, 2012  ($000's)	Value
Due in one year or less	$	124
Due after one year through five years		544
Due after five years through ten years		752
Due after ten years		1,178
		2,598
Mortgage-backed securities		74,612
Equity securities		4,342
Total securities available for sale	$	81,552

During the three and nine months ended September 30, 2012, the Company had no sales of securities. During the three months ended September 30, 2011, the Company sold mortgage-backed securities classified as available for sale having a carrying value of $19.6 million and recognized a $135,000 gain on the sales.  Other mortgage-backed securities were purchased during the same quarter totaling $19.8 million diversifying the underlying collateral of the Company’s mortgage-backed securities portfolio.  During the quarter ended June 30, 2011, equity securities consisting of Federal National Mortgage Association (“FNMA”) preferred stock and Federal Home Loan Mortgage Corporation (“FHLMC”) preferred stock that had previously been written off were sold with the Company recognizing a gain of $142,000.

During the nine months ended September 30, 2012, the Company did not recognize any other than temporary impairment loss as compared with $163,000 for same period of 2011. For the nine months ended September 30, 2011, the Company recognized impairment losses of $134,000 on Collateralized Debt Obligations ("CDOs") and $29,000 on FNMA and FHLMC preferred stocks.

At September 30, 2012 and December 31, 2011, the Company had six and seven individual securities, respectively, in an unrealized loss position.  The securities with unrealized losses at September 30, 2012 and December 31, 2011, aggregated by investment category and length of time that individual securities have been in a continuous loss position, were as follows:

11

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

	Less than 12 Months					12 Months or More				Total
	Fair		Unrealized			Fair		Unrealized		Fair		Unrealized
September 30, 2012  ($000's)	Value		Losses			Value		Losses		Value		Losses
States and political subdivisions	$	817	$	(8	)	$	0	$	0	$	817	$	(8	)
Total temporarily impaired	$	817	$	(8	)	$	0	$	0	$	817	$	(8	)

	Less than 12 Months					12 Months or More				Total
	Fair		Unrealized			Fair		Unrealized		Fair		Unrealized
December 31, 2011  ($000's)	Value		Losses			Value		Losses		Value		Losses
States and political subdivisions	$	941	$	(10	)	$	0	$	0	$	941	$	(10	)
Total temporarily impaired	$	941	$	(10	)	$	0	$	0	$	941	$	(10	)

Management has the intent and ability to hold these securities in an unrealized loss position for the foreseeable future. Management believes that it is unlikely that the Company will be required to sell the securities while they are in an unrealized loss position.

Note 5 – Subordinated Debentures

During September 2005, the Company issued $10.3 million of subordinated debentures to Northern States Statutory Trust I, a wholly-owned grantor trust, which in turn issued $10.3 million of trust preferred securities.  The Company is required to hold $310,000 of the trust preferred securities as Common Securities while the remaining $10 million were issued as Capital Securities.  The subordinated debentures mature in September 2035.   The subordinated debentures currently and until maturity bear an interest rate of the 3-month London Interbank Offered Rate (“LIBOR”) plus 1.80% adjusted quarterly.  The rate on the subordinated debentures was 2.19% at September 30, 2012, which is the effective rate from September 17, 2012 through December 16, 2012.  For the three months ended September 30, 2012 and 2011, interest expense on the subordinated debentures was $64,000 and $58,000, respectively.  For the nine months ended September 30, 2012 and 2011, interest expense on the subordinated debentures was $193,000 and $172,000, respectively.

The Company has guaranteed the payment of distributions and payments upon liquidation or redemption of the trust preferred securities, in each case to the extent of funds held by the Trust. The Company and the Trust believe that, taken together, the obligations of the Company under the guarantee, the subordinated debentures, and other related agreements provide, in the aggregate, a full, irrevocable and unconditional guarantee, on a subordinated basis, of all of the obligations of the Trust under the trust preferred securities. Subject to certain limitations, the Company has the right to defer the payment of interest on the junior subordinated debentures at any time, or from time to time, for a period not to exceed 20 consecutive quarters.  In November 2009, the Company notified the trustee that holds the Company’s junior subordinated debentures relating to its outstanding trust preferred securities that the Company would be deferring its regularly scheduled quarterly interest payments.  The Company has continued to defer its quarterly interest payments through September 30, 2012.  As of September 30, 2012, the Company had deferred twelve quarterly payments and accrued interest payable on the subordinated debentures totaled $937,000.  During the deferral period, the Company may not pay any dividends on its common or preferred stock. The trust preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the subordinated debentures at maturity or their earlier redemption. The subordinated debentures were callable at par beginning on September 15, 2010 at the discretion of the Company if certain conditions are met, and in any event, only after the Company obtains Federal Reserve approval, if required under applicable guidelines or regulations.  Subject to certain exceptions, the Company may not without the consent of the Treasury Department engage in repurchases of the Company’s common stock or trust preferred securities until all shares of Series A Preferred Stock issued to the Treasury Department have been redeemed or transferred by the Treasury Department.

12

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

Regulations currently allow bank holding companies and banks to include subordinated debentures, subject to some limitations, as a component of capital for the purpose of meeting certain regulatory requirements.  However, this treatment may be eliminated in the future under newly proposed capital rules.

Note 6 – Allowance for Loan and Lease Losses and Credit Disclosures

The allowance for loan and lease losses (“ALLL”) is a valuation allowance for probable incurred credit losses, increased by the provision for loan and lease losses and decreased by charge-offs net of recoveries. The ALLL represents one of the most significant estimates in the Bank’s financial condition. Accordingly, the Bank endeavors to provide a comprehensive and systematic approach for determining management’s current judgment about the credit quality of the loan portfolio.

At the end of each quarter, or more frequently if warranted, the Bank analyzes its loan portfolio to determine the level of ALLL needed to be maintained.  Management believes this analysis results in a prudent, conservative ALLL that falls within an acceptable range of estimated credit losses. The ALLL covers estimated credit losses on individually evaluated loans that are determined to be impaired as well as estimated credit losses inherent in the remainder of the loan portfolio.

Senior management and other lenders review all Watch and Substandard credits to determine if a loan is impaired. A loan is considered impaired if it is probable that full principal and interest will not be collected within the contractual terms of the original note. For loans that are individually evaluated and determined to be impaired, the Bank calculates the amount of impairment based on whether repayment of the loan is dependent on operating cash flow or on the underlying collateral. The decision of which method to use is determined by looking at a number of factors, including the size of the loan and other available information. If the loan is to be repaid primarily from the operating cash flow from the borrower, the impairment analysis calculates the present value of the expected future cash flows discounted at the loan’s effective interest rate and compares the result to the recorded investment. Collateral-dependent loans are measured against the fair value of the collateral less the costs to sell.

Management further segregates a component of loans considered to be “high risk” but lacking sufficient weakness to be considered impaired. These loans are assigned a specific percentage allocation, adjusted by environmental and qualitative factors management believes may affect the repayment of these loans.

The remaining loan portfolio is segmented into groups based on loan types having similar risk characteristics. Estimated loan losses for these groups are determined using historical loss experience and adjusted for other environmental and qualitative factors the Bank deems significant that would likely cause estimated credit losses to differ from the group’s historical loss experience.

Allocations of the ALLL may be made for specific loans and leases, but the entire allowance is available for any loan or lease that, in management’s judgment, should be charged-off. Loan and lease losses are charged against the allowance when management believes the uncollectibility of a loan or lease balance is confirmed.

13

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

It is the Company’s policy to administer and pursue charged-off borrowers with the same diligence as other loans.  Charging off an exposure is an accounting entry and does not affect the borrower’s obligation to repay the indebtedness.  Administration of charged-off exposure is governed by maximization of recoveries, and borrowers will be pursued until, in the opinion of management, future costs of collection exceed probable future recoveries.

Activity in the allowance for loan and lease losses for the three and nine months ended September 30, 2012 and 2011 is set forth below:

For the Three Months Ended	Beginning										Ending
September 30, 2012  ($000's)	Balance					Recoveries		Provision			Balance
	Allowance					to Loans		Charges to			Allowance
	for Loan		Loans			Previously		Operating			for Loan
	Losses		Charged-Off			Charged-Off		Expense			Losses
Commercial	$	930	$	(123	)	$	3	$	32		$	842
Real estate-construction		1,399		(165	)		0		847			2,081
Real estate-mortgage 1-4 family		889		(8	)		18		(22	)		877
Real estate-mortgage 5+ family		1,548		0			0		345			1,893
Real estate-mortgage commercial		9,245		0			30		586			9,861
Home equity		796		(99	)		0		296			993
Leases		0		0			0		0			0
Installment		9		(13	)		0		16			12
Total	$	14,816	$	(408	)	$	51	$	2,100		$	16,559

For the Three Months Ended	Beginning										Ending
September 30, 2011  ($000's)	Balance					Recoveries		Provision			Balance
	Allowance					to Loans		Charges to			Allowance
	for Loan		Loans			Previously		Operating			for Loan
	Losses		Charged-Off			Charged-Off		Expense			Losses
Commercial	$	1,178	$	(853	)	$	19	$	396		$	740
Real estate-construction		2,258		(325	)		0		482			2,415
Real estate-mortgage 1-4 family		865		(19	)		3		(301	)		548
Real estate-mortgage 5+ family		2,065		(3,121	)		0		2,626			1,570
Real estate-mortgage commercial		14,152		(367	)		0		(1,281	)		12,504
Home equity		467		(32	)		0		80			515
Leases		0		0			0		0			0
Installment		18		0			1		(2	)		17
Total	$	21,003	$	(4,717	)	$	23	$	2,000		$	18,309

14

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

For the Nine Months Ended	Beginning									Ending
September 30, 2012  ($000's)	Balance					Recoveries		Provision		Balance
	Allowance					to Loans		Charges to		Allowance
	for Loan		Loans			Previously		Operating		for Loan
	Losses		Charged-Off			Charged-Off		Expense		Losses
Commercial	$	792	$	(620	)	$	3	$	667	$	842
Real estate-construction		3,149		(2,569	)		0		1,501		2,081
Real estate-mortgage 1-4 family		865		(198	)		20		190		877
Real estate-mortgage 5+ family		1,646		0			0		247		1,893
Real estate-mortgage commercial		12,018		(4,594	)		30		2,407		9,861
Home equity		500		(582	)		0		1,075		993
Leases		0		0			0		0		0
Installment		14		(16	)		1		13		12
Total	$	18,984	$	(8,579	)	$	54	$	6,100	$	16,559

For the Nine Months Ended	Beginning										Ending
September 30, 2011  ($000's)	Balance					Recoveries		Provision			Balance
	Allowance					to Loans		Charges to			Allowance
	for Loan		Loans			Previously		Operating			for Loan
	Losses		Charged-Off			Charged-Off		Expense			Losses
Commercial	$	1,013	$	(911	)	$	51	$	587		$	740
Real estate-construction		2,842		(326	)		0		(101	)		2,415
Real estate-mortgage 1-4 family		988		(273	)		3		(170	)		548
Real estate-mortgage 5+ family		1,025		(3,121	)		0		3,666			1,570
Real estate-mortgage commercial		11,977		(1,117	)		0		1,644			12,504
Home equity		468		(32	)		0		79			515
Leases		0		0			0		0			0
Installment		23		(4	)		3		(5	)		17
Total	$	18,336	$	(5,784	)	$	57	$	5,700		$	18,309

15

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

Nonaccrual Loans:   Accrual of uncollectible income on problem loans inflates income and, when reversed, can have a dramatic negative impact on earnings.  Any loan meeting one of the following criteria is placed in a nonaccrual status and all related interest earned but not collected is reversed:

A. The loan is maintained on a cash basis because of deterioration in the financial condition of the borrower.

B. The borrower is in bankruptcy and the exposure is not fully secured and in the process of collection.

C. Full payment of principal or interest is not expected.

D. The loan has been in default for a period of ninety (90) days or more unless the asset is both well secured and in the process of collection.

Loans meeting any of the criteria above may be exempted from this policy if unanimously agreed upon and duly documented by the Directors Loan Committee. In general, all accrued interest on an exposure placed on nonaccrual status is charged-off to income. A loan may be returned to accrual status if the borrower demonstrates repayment performance for a reasonable period prior to the date the loan is returned to accrual status.  A reasonable period of repayment performance would be a period of at least six months, but may be less depending on the particular circumstances.

The Company is attempting to work with nonaccrual borrowers to resolve the issues, but in many cases the Company may have to foreclose on the properties securing these loans if the loans are secured by real estate.

Troubled Debt Restructuring (“TDR”):  Restructuring of loans is undertaken to improve the likelihood that the loan will be repaid in full under the modified terms in accordance with a reasonable repayment schedule. All restructured loans are evaluated to determine whether the loans should be reported as a TDR. A loan is a TDR when the Company, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower by modifying or renewing a loan that the Company would not otherwise consider. To make this determination the Bank must determine whether (a) the borrower is experiencing financial difficulties and (b) the Company granted the borrower a concession. This determination requires consideration of all of the facts and circumstances surrounding the modification. An overall general decline in the economy or some deterioration in a borrower’s financial condition does not automatically mean the borrower is experiencing financial difficulties.

Some of the factors reviewed to determine whether the borrower is experiencing financial difficulties are: 1) is the borrower currently in default on any of its debts; 2) has the borrower declared or in the process of declaring bankruptcy; or 3) absent the current modification, would the borrower more than likely default. Factors to consider in determining whether the Company has granted a concession include: lowering the interest rate, extending the maturity date, forgiving debt, reducing accrued interest or changing the payment to interest only for an extended period of time.

For regulatory purposes, a restructured loan classified as a TDR may not need to continue to be reported as such in calendar years after the year in which the restructuring took place if the loan yields a market rate and is in compliance with the loan’s modified terms. In determining whether the rate is a market rate the Company considers the riskiness of the transaction, the structure of the loan, the borrower’s financial condition, financial support of the guarantor and protection provided by the collateral. The Company also considers rates given to other borrowers for similar loans as well as what competitors are offering. To be in compliance with the modified loan terms the borrower should normally demonstrate the ability to repay under the modified terms for a period of at least six months and provide evidence to support that payments will continue.

16

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

Loan Rating System:  Senior management and the Bank’s lenders use a loan rating system to determine the credit risks of the Bank’s loan and leases with the following loan ratings:

Pass:  A Pass loan has no apparent weaknesses.

Watch:  A Watch loan has potential weaknesses that deserve management’s close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date.  Loan collection is not in jeopardy yet, but continued adverse trends may cause it to be.  Typical characteristics of Watch assets include:  increasing debt; liquidity problems; negative trends in operating cash flow; collateral dependent with advances outside policy guidelines; and/or sporadic payment performance.

Substandard:  A Substandard loan is inadequately protected by the current sound net worth and paying capacity of the borrower or of the collateral pledged, if any.  These loans have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt and have a distinct possibility that the Company may sustain some loss if the deficiencies are not corrected.

Nonaccrual: Loans in this category have the same characteristics as those classified Substandard with the added characteristic that further erosion in the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable.  The likelihood of loss is yet to be fully determined due to the borrower’s inability or refusal to provide updated financial information, appraisals or additional collateral.

Doubtful:  Loans in this category have the weaknesses of those classified Substandard where collection and/or liquidation in full, on the basis of currently existing conditions, is highly questionable or improbable.  Treatment as “loss” is deferred until exact status can be determined.

Loss:  Loans classified loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted.  This classification does not mean that the loan has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless loan even though partial recovery may be affected in the future.

Below shows the allocation of the allowance for loan and lease losses by segment to loans and leases individually and collectively evaluated for impairment:

17

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

					Allowance				Allowance
					for Loan				for Loan
					Losses				Losses
	Ending				Allocated to				Allocated to
	Balance		Loans		Loans		Loans		Loans
	Total		Individually		Individually		Collectively		Collectively
	Loans		Evaluated		Evaluated		Evaluated		Evaluated
	and		for		for		for		for
At September 30, 2012  ($000's)	Leases		Impairment		Impairment		Impairment		Impairment
Commercial	$	13,579	$	123	$	110	$	13,456	$	732
Real estate-construction		22,454		14,379		913		8,075		1,168
Real estate-mortgage 1-4 family		33,043		2,626		329		30,417		548
Real estate-mortgage 5+ family		30,121		700		0		29,421		1,893
Real estate-mortgage commercial		164,271		49,263		7,137		115,008		2,724
Home equity		18,920		1,397		403		17,523		590
Leases		186		0		0		186		0
Installment		1,293		0		0		1,293		12
Balance at September 30, 2012	$	283,867	$	68,488	$	8,892	$	215,379	$	7,667

					Allowance				Allowance
					for Loan				for Loan
					Losses				Losses
	Ending				Allocated to				Allocated to
	Balance		Loans		Loans		Loans		Loans
	Total		Individually		Individually		Collectively		Collectively
	Loans		Evaluated		Evaluated		Evaluated		Evaluated
	and		for		for		for		for
At December 31, 2011  ($000's)	Leases		Impairment		Impairment		Impairment		Impairment
Commercial	$	15,827	$	655	$	273	$	15,172	$	519
Real estate-construction		28,504		6,876		2,044		21,628		1,105
Real estate-mortgage 1-4 family		35,758		5,163		396		30,595		469
Real estate-mortgage 5+ family		35,977		3,987		0		31,990		1,646
Real estate-mortgage commercial		183,881		54,074		8,561		129,807		3,457
Home equity		21,266		443		141		20,823		359
Leases		295		0		0		295		0
Installment		1,476		0		0		1,476		14
Balance at December 31, 2011	$	322,984	$	71,198	$	11,415	$	251,786	$	7,569

Below shows the age analysis of the past due loans and leases by segment and class at September 30, 2012 and December 31, 2011:

18

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

													Greater
													Than
													90 Days Past
At September 30, 2012 ($000's)							Greater				Total		Due and
			30-59 Days		60-89 Days		Than 90 Days		Total		Loans and		Still
	Current		Past Due		Past Due		Past Due		Past Due		Leases		Accruing
Commercial	$	13,478	$	55	$	2	$	44	$	101	$	13,579	$	23
Real estate-construction
1-4 family		11,441		0		0		1,266		1,266		12,707		1,248
Other		9,530		0		0		217		217		9,747		0
Real estate-mortgage
1-4 family		31,268		181		615		979		1,775		33,043		497
Real estate-mortgage
5+ family		29,051		275		197		598		1,070		30,121		598
Real estate-mortgage commercial
Owner occupied		43,145		182		0		3,893		4,075		47,220		0
Non-owner occupied		58,909		924		1,468		9,396		11,788		70,697		0
Hotel industry		43,638		0		0		2,716		2,716		46,354		0
Home equity		16,607		811		74		1,428		2,313		18,920		31
Leases		186		0		0		0		0		186		0
Installment		1,232		60		1		0		61		1,293		0
Balance at September 30, 2012	$	258,485	$	2,488	$	2,357	$	20,537	$	25,382	$	283,867	$	2,397

													Greater
													Than
													90 Days Past
At December 31, 2011 ($000's)							Greater				Total		Due and
			30-59 Days		60-89 Days		Than 90 Days		Total		Loans and		Still
	Current		Past Due		Past Due		Past Due		Past Due		Leases		Accruing
Commercial	$	15,273	$	6	$	0	$	548	$	554	$	15,827	$	0
Real estate-construction
1-4 family		14,084		0		0		2,716		2,716		16,800		152
Other		9,820		0		0		1,884		1,884		11,704		0
Real estate-mortgage
1-4 family		32,539		1,672		284		1,263		3,219		35,758		0
Real estate-mortgage
5+ family		32,227		0		0		3,750		3,750		35,977		0
Real estate-mortgage commercial
Owner occupied		53,911		265		471		7,850		8,586		62,497		0
Non-owner occupied		73,162		575		227		450		1,252		74,414		0
Hotel industry		46,970		0		0		0		0		46,970		0
Home equity		20,288		206		71		701		978		21,266		322
Leases		295		0		0		0		0		295		0
Installment		1,442		15		3		16		34		1,476		16
Balance at December 31, 2011	$	300,011	$	2,739	$	1,056	$	19,178	$	22,973	$	322,984	$	490

The Company utilizes a loan rating system as a means of identifying problem and potential loans.  Below shows the loan ratings of loans and leases by segment and class at September 30, 2012 and December 31, 2011:

19

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

At September 30, 2012 ($000's)	Pass		Watch		Substandard		Nonaccrual		Total
Commercial	$	11,074	$	2,381	$	103	$	21	$	13,579
Real estate-construction
1-4 Family		1,844		113		10,732		18		12,707
Other		259		0		9,271		217		9,747
Real estate-mortgage
1-4 family		23,686		5,647		3,179		531		33,043
Real estate-mortgage
5+ family		17,903		8,204		4,014		0		30,121
Real estate-mortgage commercial
Owner occupied		23,161		9,354		10,812		3,893		47,220
Non-owner occupied		40,065		8,371		12,865		9,396		70,697
Hotel industry		3,696		19,959		19,983		2,716		46,354
Home equity		16,693		293		537		1,397		18,920
Leases		186		0		0		0		186
Installment		1,293		0		0		0		1,293
Balance at September 30, 2012	$	139,860	$	54,322	$	71,496	$	18,189	$	283,867

At December 31, 2011 ($000's)	Pass		Watch		Substandard		Nonaccrual		Total
Commercial	$	12,587	$	2,247	$	445	$	548	$	15,827
Real estate-construction
1-4 Family		2,345		4,230		7,662		2,563		16,800
Other		277		6,602		2,941		1,884		11,704
Real estate-mortgage
1-4 family		25,430		4,968		4,097		1,263		35,758
Real estate-mortgage
5+ family		25,105		6,885		0		3,987		35,977
Real estate-mortgage commercial
Owner occupied		31,778		12,211		10,186		8,322		62,497
Non-owner occupied		41,096		20,031		12,837		450		74,414
Hotel industry		3,784		9,358		33,828		0		46,970
Home equity		19,527		792		504		443		21,266
Leases		247		48		0		0		295
Installment		1,476		0		0		0		1,476
Balance at December 31, 2011	$	163,652	$	67,372	$	72,500	$	19,460	$	322,984

The following tables present loans and leases by segment and class individually evaluated for impairment at September 30, 2012 and December 31, 2011 and the average recorded investment and investment income recognized for the nine months ended September 30, 2012 and for the year ended December 31, 2011:

20

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

($000's)							For the Nine Months
	At September 30, 2012						Ended September 30, 2012
			Unpaid				Average		Investment
	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized
With no related allowance recorded:
Commercial	$	0	$	0	$	0	$	0	$	0
Real estate-construction
1-4 family		7,719		7,719		0		7,341		111
Other		4,228		6,479		0		3,679		75
Real estate-mortgage 1-4 family		543		621		0		1,067		24
Real estate-mortgage 5+ family		700		700		0		3,617		0
Real estate-mortgage commercial
Owner occupied		6,119		6,119		0		4,752		115
Non-owner occupied		4,951		4,951		0		4,959		96
Hotel industry		3,006		3,006		0		4,760		96
Home equity		258		445		0		203		0
Leases		0		0		0		0		0
Installment		0		0		0		0		0
With an allowance recorded:
Commercial		123		123		110		437		5
Real estate-construction
1-4 family		2,432		2,432		913		1,396		83
Other		0		0		0		639		0
Real estate-mortgage 1-4 family		2,083		2,116		329		2,108		48
Real estate-mortgage 5+ family		0		0		0		0		0
Real estate-mortgage commercial
Owner occupied		7,889		10,520		615		9,598		145
Non-owner occupied		7,604		7,604		652		1,104		12
Hotel industry		19,694		23,294		5,870		24,124		779
Home equity		1,139		1,139		403		595		0
Leases		0		0		0		0		0
Installment		0		0		0		0		0
Total:
Commercial	$	123	$	123	$	110	$	437	$	5
Real estate-construction		14,379		16,630		913		13,055		269
Real estate-mortgage 1-4 family		2,626		2,737		329		3,175		72
Real estate-mortgage 5+ family		700		700		0		3,617		0
Real estate-mortgage commercial		49,263		55,494		7,137		49,297		1,243
Home equity		1,397		1,584		403		798		0
Leases		0		0		0		0		0
Installment		0		0		0		0		0
Total	$	68,488	$	77,268	$	8,892	$	70,379	$	1,589

21

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

($000's)							For the Year
	At December 31, 2011						Ended December 31, 2011
			Unpaid				Average		Investment
	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized
With no related allowance recorded:
Commercial	$	0	$	0	$	0	$	152	$	0
Real estate-construction
1-4 family		34		34		0		4,607		176
Other		734		2,468		0		1,109		0
Real estate-mortgage 1-4 family		2,039		2,039		0		3,391		96
Real estate-mortgage 5+ family		3,987		3,987		0		8,856		38
Real estate-mortgage commercial
Owner occupied		5,254		5,254		0		6,333		185
Non-owner occupied		3,927		3,927		0		10,281		408
Hotel industry		3,034		3,034		0		2,758		132
Home equity		30		30		0		67		20
Leases		0		0		0		0		0
Installment		0		0		0		0		0
With an allowance recorded:
Commercial		655		1,416		273		1,026		1
Real estate-construction
1-4 family		4,958		4,958		1,960		4,861		103
Other		1,150		1,150		84		1,150		22
Real estate-mortgage 1-4 family		3,124		3,124		396		2,899		131
Real estate-mortgage 5+ family		0		0		0		0		0
Real estate-mortgage commercial
Owner occupied		10,319		10,319		2,974		9,549		97
Non-owner occupied		746		746		458		746		2
Hotel industry		30,794		34,393		5,129		31,523		1,139
Home equity		413		413		141		1,621		2
Leases		0		0		0		0		0
Installment		0		0		0		6		1
Total:
Commercial	$	655	$	1,416	$	273	$	1,178	$	1
Real estate-construction		6,876		8,610		2,044		11,727		301
Real estate-mortgage 1-4 family		5,163		5,163		396		6,290		227
Real estate-mortgage 5+ family		3,987		3,987		0		8,856		38
Real estate-mortgage commercial		54,074		57,673		8,561		61,190		1,963
Home equity		443		443		141		1,688		22
Leases		0		0		0		0		0
Installment		0		0		0		6		1
Total	$	71,198	$	77,292	$	11,415	$	90,935	$	2,553

22

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

The following table presents the number of loans and leases modified as TDRs by segment and class during the three and nine month period ended September 30, 2012, the outstanding recorded balances at the time modified and the outstanding recorded investment balances at September 30, 2012:

	Loans Classified as Trouble Debt Restructured
	During the Three Months Ended						During the Nine Months Ended
	September 30, 2012						September 30, 2012
			Pre-Modification		Post-Modification				Pre-Modification		Post-Modification
			Outstanding		Outstanding				Outstanding		Outstanding
	Number of		Recorded		Recorded		Number of		Recorded		Recorded
	Loans		Investment		Investment		Loans		Investment		Investment
Commercial		0	$	0	$	0		0	$	0	$	0
Real estate-construction
1-4 family		1		3,238		3,238		2		7,719		7,719
Other		0		0		0		1		4,012		4,012
Real estate-mortgage 1-4 family		1		130		130		2		495		495
Real estate-mortgage 5+ family		1		700		700		1		700		700
Real estate-mortgage commercial
Owner occupied		2		625		625		3		3,234		3,195
Non-owner occupied		0		0		0		1		332		325
Hotel industry		0		0		0		0		0		0
Home equity		0		0		0		0		0		0
Leases		0		0		0		0		0		0
Installment		0		0		0		0		0		0
At September 30, 2012		5	$	4,693	$	4,693		10	$	16,492	$	16,446

There were no loans or leases modified as TDRs during the previous twelve month period that subsequently defaulted during the three and nine month periods ended September 30, 2012.  Defaulted TDRs are those TDR loans greater than 90 days past due and still accruing or on nonaccrual status.

Note 7 - Fair Value Measurement

The following methods and assumptions were used to estimate fair values for financial instruments.  Securities fair values are based on quoted market prices or, if no quotes are available, on the rate and term of the security and/or information about the issuer.  For loans, leases, deposits, securities sold under repurchase agreements and fixed-rate FHLB advances, the fair value is estimated by discounted cash flow analysis using market rates for the estimated life and credit risk.  Fair values for impaired loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.  The fair value of off-balance sheet items is based on the fees or cost that would currently be charged to enter into or terminate such arrangements, and the amount is not considered material.  Fair value for cash and cash equivalents, accrued interest receivable, advances from borrowers for taxes and insurance and accrued interest payable are estimated at carrying value. The estimated fair value for Federal Home Loan Bank stock is equal to the carrying value based on the restricted nature of the stock.

23

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

The estimated fair values of financial instruments at September 30, 2012 and December 31, 2011 were:

September 30, 2012  ($000's)	Carrying			Estimated Fair Value
	Value			Total			Level 1			Level 2			Level 3
Financial assets:
Cash and cash equivalents	$	41,212		$	41,212		$	41,212		$	0		$	0
Interest bearing deposits in financial institutions - maturities of 90 days or greater		2,976			2,976			2,976			0			0
Securities available for sale		81,552			81,552			4,342			76,393			817
Loans and leases, net		267,197			278,844			0			0			278,844
Federal Home Loan Bank stock		931			931			0			0			931
Accrued interest receivable		1,191			1,191			0			1,191			0
Financial liabilities:
Deposits	$	(359,973	)	$	(359,997	)	$	(249,833	)	$	(110,164	)	$	0
Securities sold under repurchase agreements		(19,726	)		(19,674	)		0			(19,674	)		0
Subordinated debentures		(10,310	)		(4,574	)		0			0			(4,574	)
Advances from borrowers for taxes and insurance		(552	)		(552	)		(552	)		0			0
Accrued interest payable		(1,156	)		(1,156	)		0			(1,156	)		0

December 31, 2011  ($000's)	Carrying			Estimated Fair Value
	Value			Total			Level 1			Level 2			Level 3
Financial assets:
Cash and cash equivalents	$	37,833		$	37,833		$	37,833		$	0		$	0
Securities available for sale		87,140			87,140			4,261			81,934			945
Loans and leases, net		303,729			313,338			0			0			313,338
Federal Home Loan Bank stock		1,801			1,801			0			0			1,801
Accrued interest receivable		1,401			1,401			0			1,401			0
Financial liabilities:
Deposits	$	(397,631	)	$	(397,885	)	$	(245,314	)	$	(152,571	)	$	0
Securities sold under repurchase agreements		(19,455	)		(19,417	)		0			(19,417	)		0
Subordinated debentures		(10,310	)		(4,375	)		0			0			(4,375	)
Advances from borrowers for taxes and insurance		(1,222	)		(1,222	)		(1,222	)		0			0
Accrued interest payable		(1,127	)		(1,127	)		0			(1,127	)		0

24

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

In general, fair values determined by Level 1 inputs use a quoted price in active markets for identical securities that the Company had the ability to access.

Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly.  These Level 2 inputs include quoted prices for similar securities in active markets, and other input such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related securities.

In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest input that is significant to the valuation.  The Company's assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each security.

On an annual basis the Company validates the measurement of the fair values of its securities with an independent securities valuation firm. This independent securities valuation firm determines the fair values of the securities portfolio that is then compared to the fair value using the methods outlined.  When this validation was last done on September 30, 2011, the difference between the fair value reported and the fair value determined by the independent securities valuation firm was considered immaterial.

The table below shows information about the Company's securities that were measured at fair value and the valuation techniques used by the Company to determine fair values.

Securities Available for Sale ($000's)			Fair Value Measurements at Reporting Date Using
			Quoted Prices
			in Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
States and political subdivisions	$	2,598	$	0	$	1,781	$	817
Mortgage-backed securities		74,612		0		74,612		0
Equity securities		4,342		4,342		0		0
At September 30, 2012	$	81,552	$	4,342	$	76,393	$	817
States and political subdivisions	$	3,117	$	0	$	2,172	$	945
Mortgage-backed securities		79,762		0		79,762		0
Equity securities		4,261		4,261		0		0
At December 31, 2011	$	87,140	$	4,261	$	81,934	$	945

The Company's change in Level 3 securities measured at fair value on a recurring basis was as follows:

25

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

	Securities
	Available
	for Sale ($000's)
Balance at December 31, 2011	$	945
Total realized and unrealized gains (losses) included in income		0
Total unrealized gains (losses) included in other comprehensive income		0
Net purchase, sales, calls and maturities		(128	)
Net transfer into Level 3		0
Balance at September 30, 2012	$	817

	Securities
	Available
	for Sale ($000's)
Balance at December 31, 2010	$	20
Total realized and unrealized gains (losses) included in income		(163	)
Total unrealized gains (losses) included in other comprehensive income		143
Net purchase, sales, calls and maturities		0
Net transfer into Level 3		0
Balance at September 30, 2011	$	0

At year-end 2011, the Company had nonrated securities issued by a local municipality totaling $945,000 in which the fair value was determined using significant unobservable inputs, or Level 3, based on an outside investment broker’s analysis of the financial condition of the municipality issuing the securities. During the nine months ended September 30, 2012, $128,000 of these Level 3 securities matured.

The Company used accounting guidelines to determine other than temporary impairment losses on its Collateralized Debt Obligations ("CDOs") as the fair value of these securities was not readily determinable by the market.  The impairment losses on the CDOs were due to defaults and deferrals of payments by the financial institutions and insurance companies that issued the debt underlying the securities. During the quarter ended March 31, 2011, the Company used cash flow analyses on its CDOs to determine other than temporary impairment losses of $134,000, fully writing off the remaining book value of these securities.

During the quarter ended March 31, 2011, the Company recognized other than temporary impairment losses on its equity securities consisting of preferred stock issued by the Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”) of $29,000, fully writing off the remaining book value of these securities.

The Company also has assets that under certain conditions are subject to measurement at fair value on a nonrecurring basis.  These assets are held to maturity loans or other real estate owned that are considered impaired per accounting principles.  The Company has estimated the fair value of these impaired assets using Level 3 inputs, specifically discounted cash flow projections or fair value of collateral.

26

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

During the nine months ended September 30, 2012 and 2011, the Company recorded adjustments to certain collateral dependent loans that were measured for impairment in accordance with accounting guidelines.  In cases where the carrying value of the loans exceed the estimated fair value of the collateral less estimated costs to sell, an impairment loss was recognized.  The Company also recorded adjustments to certain cash flow dependent loans consisting primarily of troubled debt restructured loans that were measured for impairment in accordance with accounting guidelines.  In the case of cash flow dependent troubled debt restructured loans, impairment was determined by comparing the discounted cash flows with the Company’s recorded investment.  The Company had allocations for impaired loans totaling $5.9 million and $6.0 million for the nine months ended September 30, 2012 and 2011, respectively.

Impaired Loans ($000's)			Fair Value Measurements at Reporting Date Using
			Quoted Prices
			in Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
At September 30, 2012	$	32,580	$	0	$	0	$	32,580
At December 31, 2011	$	40,744	$	0	$	0	$	40,744

During the quarter ended September 30, 2012, the Company recorded adjustments of $1.2 million to certain properties carried as other real estate owned as compared to adjustments of $797,000 for the same quarter of 2011.  Such write-downs are generally based on the estimated underlying fair values of the properties less estimated costs to sell.  In cases where the carrying value of the property exceeds the estimated fair value, an impairment loss is recognized. During the nine months ended September 30, 2012 and September 30, 2011, the Company recorded $3.9 million and $2.1 million, respectively, in write-down adjustments to other real estate owned.

Impaired Other Real Estate Owned ($000's)			Fair Value Measurements at Reporting Date Using
			Quoted Prices
			in Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
At September 30, 2012	$	12,557	$	0	$	0	$	12,557
At December 31, 2011	$	18,300	$	0	$	0	$	18,300

27

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

Note 8 – Consent Order and Written Agreement

On April 16, 2010, the Company’s wholly-owned subsidiary, NorStates Bank (the “Bank”), and the regulators, the Federal Deposit Insurance Corporation (the “FDIC”) and the Illinois Department of Financial and Professional Regulation (the “IDFPR”), entered into a joint Consent Order.  Pursuant to the Consent Order, among other things, the Bank has agreed to undertake the following:

(1) increase the participation of the Bank’s Board of Directors in overseeing and supervising the affairs and activities of the Bank, including holding meetings of the Board no less frequently than monthly;

(2) adopt and implement a program for monitoring compliance with the Consent Order, including establishing a committee comprised of at least three outside Bank board members responsible for such oversight;

(3) maintain a Tier 1 capital to total assets ratio of at least 8% and a total risk-based capital ratio of at least 12%;

(4) prohibit the extension of additional credit to or for the benefit of any existing borrower with a loan that has been previously charged-off or classified “loss” by the examiners, as well as prohibit the extension of additional credit in any amount in excess of $10,000 to any existing borrower with an outstanding loan classified as “substandard”, “doubtful” or “special mention” unless the Board of Directors or a committee thereof determines the loan to be in the best interests of the Bank;

(5) adopt a written action plan with respect to each classified asset and delinquent loan in excess of $1,000,000 for the purpose of reducing the Bank’s risk position with respect to such asset;

(6) correct all deficiencies in the loans listed as “special mention” by the examiners;

(7) adopt a written action plan to reduce and manage concentrations of credit identified by the examiners, including procedures that provide for the ongoing measurement and monitoring of the concentrations of credit, the performance of portfolio stress testing analysis and the setting of concentration limits commensurate with the Bank’s capital levels and overall risk profile;

(8) provide for quarterly reviews of and adjustments to the allowance for loan and lease losses in accordance with bank regulatory guidelines;

(9) implement revised written lending and collection policies as indicated by the examiners, as well as revised loan grading and review procedures, including procedures for periodic confirmation of the accuracy and completeness of the watch list and all risk grade assignments, identification of loan relationships that warrant special management attention, and identification and tracking of credit and collateral documentation exceptions;

(10) adopt a written profit plan and comprehensive budget containing formal goals and strategies to reduce discretionary expenses and to improve the Bank’s overall earnings;

28

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

(11) adopt a written contingency funding/liquidity plan which includes identification of the sources of liquid assets available to meet the Bank’s contingency funding needs over one-, two- and three-month time horizons; and

(12) adopt a revised investment policy and interest rate risk policy to address the recommendations of the examiners.

The Consent Order also prohibits the payment of any dividends by the Bank to the Company without the prior written consent of both the FDIC and the IDFPR.

Because the Consent Order establishes specific capital amounts to be maintained by the Bank, the Bank may not be considered better than “adequately capitalized” for capital adequacy purposes, even if the Bank exceeds the levels of capital set forth in the Consent Order.

As an adequately capitalized institution, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC.  Brokered deposits also include deposits with rates of interest that are more than 75 basis points above the rates applicable to the market of the Bank as determined by the FDIC.  The FDIC has approved that the Bank is operating in a high rate area, which allows the Bank to use local average deposit rates as a basis for setting competitive rates on its deposits.

Any material failure to comply with the provisions of the Consent Order could result in additional enforcement actions by the FDIC as allowed by 12 U.S.C. §1818 and the IDFPR. While the Company intends to take such actions as may be necessary to enable the Bank to comply with the requirements of the Consent Order, there can be no assurance that the Bank will be able to comply fully with the provisions of the Consent Order, or that efforts to comply with the Consent Order will not have adverse effects on the operations and financial condition of the Company and the Bank.

The Bank has been notified by the FDIC and IDFPR thatthe Consent Order dated April 16, 2010 will be terminated and the Bank will be required to enter into a new Consent Order .  While the new agreement has not yet been finalized, we expect that it will, among other things, require the Bank to undertake the following:

(1) continued oversight and supervision by the Board of Directors of the Bank and its management, including monitoring compliance with the Consent Order;

(2) maintain a Tier 1 capital to total assets ratio of at least 8% and a total risk-based capital ratio of at least 12%;

(3) provide an updated written capital plan detailing the steps the Bank will take to comply with the minimum capital requirements;

(4) charge- off any loans classified as “loss” and prohibit the extension of additional credit to any existing borrower with a loan that has been previously charged-off or classified “loss”; prohibit the extension of additional credit in excess of $10,000 to any existing borrower with an outstanding loan classified as “substandard,” unless determined by the Board of Directors to be in the best interests of the Bank;

(5) continue to maintain, implement and adhere to written plans to reduce the Bank’s risk position for each classified asset and delinquent loan in excess of $1,000,000, and to manage concentrations of credit, including the ongoing measurement and monitoring and the setting of concentration limits commensurate with the Bank’s capital levels and overall risk profile;

29

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

(6) not declare or pay any dividend without the prior consent of the FDIC and IDFPR;

(7) continue to implement its written profit plan and develop a budget that includes the reduction of discretionary expenses and improvement in the Bank’s overall earnings; and

(8) not increase its assets by more than 5% during any three-month period without preapproval, and no more than 15% annually.

On March 17, 2011, the Company and the Federal Reserve Bank of Chicago (“Reserve Bank”) entered into a Written Agreement.  Pursuant to the Written Agreement, among other things, the Company has agreed to undertake the following:

(1) serve as a source of strength to the Bank;

(2) abstain from paying any dividends, redeeming any stock or incurring any debt without Federal Reserve approval;

(3) adopt a capital plan;

(4) provide the Federal Reserve with cash flow projections on a quarterly basis; and

(5) notify the Federal Reserve of the proposed addition of any individual to the Board of Directors or the employment of any individual as a senior executive officer of the Company before such addition or employment becomes effective.

Any material failure to comply with the provisions of the Written Agreement could result in additional enforcement actions by the Federal Reserve Bank. While the Company intends to take such actions as may be necessary to comply with the requirements of the Written Agreement, there can be no assurance that the Company will be able to comply fully with the provisions of the Written Agreement, or that efforts to comply with the Written Agreement will not have adverse effects on the operations and financial condition of the Company.

30

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

Note 9 – Management Plans

Management and the Board of Directors are committed to complying with the terms of the Consent Order and the Written Agreement, and have already taken, and continue to take, numerous steps to address these matters.  The Bank and the Company reports to the FDIC and the IDFPR, and the Federal Reserve, respectively, quarterly regarding their progress in complying with the provisions included in the Consent Order and the Written Agreement.  Compliance with the terms of the Consent Order and the Written Agreement will be an ongoing priority for management of the Bank and the Company.

The Bank continues to dedicate significant resources to effectively identify, monitor, and manage problem assets and reduce real estate loan concentrations.  A liquidity policy has been developed to identify the sources of liquid assets available to meet the Bank’s contingency funding needs.  Dividends have already been restricted and the Company has suspended its dividend payments on its Series A Preferred Stock issued to the Treasury Department as is permissible under the terms of the TARP Capital Purchase Program and has deferred payment of interest on its subordinated debentures which is permissible under the terms of the debenture agreement.  The Bank’s Tier 1 to average assets ratio and total capital to assets ratio, on a risk adjusted basis, were 7.69 percent and 13.32 percent, respectively, as of September 30, 2012. The Bank’s Tier 1 to average assets ratio was below the capital levels required by the Consent Order of 8.00 percent while the Bank’s total capital to assets ratio, on a risk adjusted basis was above the 12.00 percent level required by the Consent Order.

In view of these matters, the Bank’s ability to improve its financial condition is dependent upon the success of management’s plans to address concerns regarding profitability and asset quality.  The Bank’s management believes they are taking appropriate steps aimed at returning the Bank to profitability and improving asset quality.  Management’s success will ultimately be determined by its implementation of its plans, as well as factors beyond its control, such as the economy and real estate market.

Management and the Board of Directors are committed to complying with the terms of the new Consent Order and have already taken, and will continue to take, numerous steps to address the matters outlined in the new Consent Order.

31

NORTHERN STATES FINANCIAL CORPORTION

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following discussion focuses on the consolidated financial condition of Northern States Financial Corporation (the “Company”) at September 30, 2012 compared to December 31, 2011 and the Company’s consolidated results of operations for the three and nine month periods ended September 30, 2012, compared with the three and nine month periods ended September 30, 2011.  The purpose of this discussion is to provide a better understanding of the condensed consolidated financial statements of the Company and the operations of its two wholly-owned subsidiaries, NorStates Bank (the “Bank”) and NorProperties, Inc. (“NorProp”), and the Bank’s wholly-owned subsidiary, Northern States Community Development Corporation (“NSCDC”). This discussion should be read in conjunction with the interim condensed consolidated unaudited financial statements and notes thereto included herein.

Statements contained in this report that are not historical facts may constitute forward-looking statements (within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended), which involve significant risks and uncertainties.  The Company intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and is including this statement for purposes of invoking these safe harbor provisions.  Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are generally identifiable by the use of the words "believe," "expect," "intend," "anticipate," "estimate," "project," "plan," or similar expressions.  The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain and actual results may differ from those predicted.  The Company undertakes no obligation to update these forward-looking statements in the future.  The Company cautions readers of this report that a number of important factors could cause the Company’s actual results subsequent to September 30, 2012 to differ materially from those expressed in forward-looking statements.  Factors that could cause actual results to differ from those predicted and could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, the potential for further deterioration in the credit quality of the Company’s loan and lease portfolios, uncertainty regarding the Company’s ability to ultimately recover on loans currently on nonaccrual status, the Company’s ability to comply with the provisions of the Consent Order and Written Agreement, further deterioration in the value of the Company’s other real estate owned, unanticipated changes in interest rates, worsening or lack of improvement in general economic conditions and the real estate market, increasing regulatory compliance burdens or potential legislative/regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the quality or composition of the Company’s loan or investment portfolios, deposit flows, liquidity issues, competition, demand for loan products and financial services in the Company’s market area, and changes in accounting principles, policies and guidelines.  These risks and uncertainties should be considered in evaluating forward-looking statements.

OVERVIEW

Total assets at September 30, 2012 were $419.4 million, a decrease of $43.6 million, or 9.4 percent, from $463.0 million at December 31, 2011 as the Company continued to reposition its balance sheet.  Loans totaled $283.8 million at September 30, 2012, a decrease of $38.9 million, or 12.1 percent, from $322.7 million at December 31, 2011.  Loans decreased $27.1 million due to scheduled principal loan payments and from loan payoffs received in the ordinary course of business.  Also contributing to the decrease in loans was the transfer of $4.1 million in loans to other real estate owned through or in lieu of foreclosure and the charge-off of $8.6 million in loans to the allowance for loan and lease losses. Other real estate owned totaled $12.8 million at September 30, 2012, decreasing $6.5 million or 33.9 percent from year-end 2011.  Other real estate owned decreased as $6.8 million of properties were sold and $3.9 million in write-downs were recognized. Partially offsetting these decreases was the transfer of $4.1 million in loans to other real estate owned.  The Company’s cash and cash equivalents totaled $41.2 million at September 30, 2012, showing an increase of $3.4 million from December 31, 2011.

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NORTHERN STATES FINANCIAL CORPORTION

The decrease in the Company’s assets was primarily offset by deposit decreases of $37.7 million to $359.9 million at September 30, 2012 compared with $397.6 million at December 31, 2011, a decrease of 9.5 percent.  Time deposits decreased $42.2 million while total other deposits consisting of demand, interest bearing demand, money market and savings deposits increased $4.5 million from December 31, 2011.  Time deposits decreased primarily from reductions of $9.6 million in brokered time deposits, $20.3 million in wholesale internet time deposits and $9.5 million in retail time deposits.

The Company’s borrowings through securities sold under repurchase agreements increased to $19.7 million at September 30, 2012 as compared with $19.5 million at December 31, 2011.

Total nonperforming loans and leases decreased $2.1 million to $69.6 million, or 24.5 percent of total loans and leases, at September 30, 2012 as compared with $71.7 million, or 22.2 percent of total loans and leases, at December 31, 2011.

The Company continued to be affected by the continued decline in general real estate prices.  For the three months ended September 30, 2012, the Company experienced a net loss available to common stockholders of $2.4 million or $0.55 per share, compared with a net loss of $2.0 million, or $0.46 per share for the same three months of 2011 as the Company continued to write down loans and other real estate owned as a result of declining values of the collateral securing these nonperforming assets.  Net interest income declined $727,000 due to a lower volume of earning assets and the reversal of $238,000 of loan interest income as loans were placed on nonaccrual status compared with only $183,000 of reversed loan interest during the same quarter of 2011.  The provision for loan and lease losses increased $100,000 and write-downs of other real estate owned increased $363,000 during the third quarter of 2012 as compared to the same quarter of 2011.  Noninterest income was $148,000 lower during the quarter as the Company sold no securities during the quarter while during the same quarter last year recognized gains of $135,000 on sales of $19.6 million of securities.  Offsetting some of these reductions to income was lower other real estate owned expense that was $649,000 less during the third quarter of 2012 as compared to the same quarter of 2011 due to rents received on these properties and decreases to carrying balances of other real estate owned.  Salaries and employee benefit expenses decreased by $220,000 during the quarter due to reductions in staff.

The Company’s net loss available to common stockholders for the nine months ended September 30, 2012 was $8.3 million, or $1.94 per share, compared with a net loss available to common stockholders of $5.9 million, or $1.37 per share for the same nine months of 2011.

CRITICAL ACCOUNTING POLICIES

Certain critical accounting policies involve estimates and assumptions by management.  To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information.  These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ.

The allowance for loan and lease losses is a valuation allowance for probable incurred credit losses that is increased by the provision for loan and lease losses and decreased by charge-offs less recoveries. Management estimates the balance for the allowance based on information about specific borrower situations, estimated collateral values, discounted cash flows and the borrowers’ ability to repay the loan. Management also reviews past loan and lease loss experience, the nature and volume of the portfolio, environmental and qualitative factors, economic conditions and other factors which may affect the repayment of loans. Allocations of the allowance may be made for specific loans and leases, but the entire allowance is available for any loan or lease that, in management’s judgment, should be charged-off. Loan and lease losses are charged against the allowance when management believes the uncollectibility of a loan or lease balance is confirmed.

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NORTHERN STATES FINANCIAL CORPORTION

A loan or lease is impaired when full payment under the loan or lease terms is not expected within the contractual terms of the loan. Impairment is evaluated on an individual loan or lease basis for impaired loans and leases. If a specific loan or lease is determined to be impaired, a portion of the allowance may be specifically allocated to that loan or lease. The specific allocation is calculated at the present value of estimated cash flows using the existing rate of the loan or lease or the fair value of collateral if repayment is expected solely from the collateral.

Other real estate owned consists of properties securing nonperforming loans obtained through, or in lieu of, foreclosure and is initially reported at the estimated fair value based on a real estate appraisal less estimated costs to sell. Other real estate is periodically assessed for impairment and any such impairment is recognized in the current period.

The fair value of securities is based on determinations from a securities broker. On an annual basis these are validated by an independent securities valuation firm. This validation was last done at September 30, 2011 and the differences in fair value were deemed to be immaterial.

There are various contingent liabilities that are not reflected in the financial statements, including claims and legal actions arising against the Company in the ordinary course of business. These matters are not expected to have a material effect on the Company’s operating results or financial condition.

The fair value of financial instruments such as cash and cash equivalents, accrued interest receivable, advances from borrowers for taxes and insurance and accrued interest payable are estimated at carrying value. The estimated fair value for Federal Home Loan Bank stock is equal to the carrying value based on the restricted nature of the stock.

The Company recognized no income tax benefit for the three or nine months ended September 30, 2012 despite having an operating loss before income taxes of $2.1 million and $7.4 million, respectively.  Per accounting rules, the Company continued to book tax benefits adjusted for timing differences as a deferred tax asset with a corresponding offset to the deferred tax asset valuation allowance, without recognizing a tax benefit on the income statement due to uncertainties as to the realization of these benefits.  The Company’s tax deferred tax asset was determined to be $21.5 million at September 30, 2012.  The Company will continue to analyze its deferred tax assets quarterly.

FINANCIAL CONDITION

The Company’s cash and cash equivalents totaled $41.2 million at September 30, 2012, increasing $3.4 million from December 31, 2011.  The Company’s interest bearing deposits in financial institutions with maturities less than 90 days, a component of cash and cash equivalents, totaled $36.7 million, an increase of $4.1 million from December 31, 2011.  These funds consisted primarily of deposits at the Federal Reserve Bank of Chicago as the interest rate paid was greater than or comparable to rates paid on federal funds sold.  At September 30, 2012, the Company had $3.0 million in time deposits in financial institutions with maturities of 90 days or greater.  These time deposits are fully insured by the FDIC and have original maturities from 90 to 550 days and earn rates ranging from 0.50 percent to 1.06 percent.

The Company’s securities available for sale declined $5.5 million, to $81.6 million at September 30, 2012 compared with $87.1 million at year-end 2011.  The decline in securities was due to the receipt of scheduled maturities and payments.   At September 30, 2012, the Company had pledged securities of $51.1 million as compared with $57.0 million at December 31, 2011.  The securities were pledged to secure public deposits, repurchase agreements and for other purposes as required or permitted by law.

Loans and leases totaled $283.8 million at September 30, 2012, a decrease of $38.9 million, or 12.1 percent, from $322.7 million at December 31, 2011.  Loans decreased by $27.1 million due to scheduled principal loan payments and loan payoffs received in the course of business.  Contributing to the decrease in loans was the transfer of $4.1 million in loans to other real estate owned through or in lieu of foreclosure and the charge-off of $8.6 million in loans to the allowance for loan and lease losses.

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NORTHERN STATES FINANCIAL CORPORTION

At September 30, 2012, approximately 95 percent of the Bank’s loan portfolio was secured by real estate.  The Company’s loans to the hotel industry totaled $46.4 million or 217 percent of total capital at September 30, 2012, decreasing slightly from $47.0 million, or 165 percent of capital at year-end 2011.  Loans totaling $29.4 million secured by 1-4 family homes and 5+ family residences at September 30, 2012 were pledged to secure a line of credit of $16.1 million from the Federal Home Loan Bank of Chicago.  At September 30, 2012, loans totaling $61.3 million had payment schedules where only interest is collected until the loans mature as compared with $96.1 million in loans at December 31, 2011.  At September 30, 2012, $17.1 million of loans having interest only payments were home equity loans.

Loan commitments declined $1.9 million to $30.3 million at September 30, 2012, compared with $32.2 million at December 31, 2011.  Letters of credit decreased during the nine months ended September 30, 2012, to $1.6 million from $2.3 million at year-end 2011.

At September 30, 2012, loans to related parties totaled $114,000 as compared with $238,000 at December 31, 2011.  Loan commitments and letters of credit issued to related parties were $97,000 at September 30, 2012 compared with $247,000 at December 31, 2011.  Loans, loan commitments and letters of credit to related parties are made on the same terms and conditions that are available to the public.

The decline in the Company’s assets was primarily offset by deposit decreases of $37.7 million to $359.9 million at September 30, 2012 compared with $397.6 million at December 31, 2011, a decrease of 9.5 percent.  Time deposits decreased $42.2 million while total other deposits consisting of demand, interest bearing demand, money market and savings deposits increased $4.5 million from December 31, 2011.  Time deposits decreased primarily from reductions of $9.6 million in brokered time deposits, $20.3 million in wholesale internet time deposits and $9.5 million in retail time deposits as the Company managed its liquidity position.  Related party deposits at September 30, 2012 totaled $4.7 million as compared with $2.1 million at year-end 2011.

At September 30, 2012, the Company’s mix of deposits changed as retail deposits increased to 73.1 percent of deposits from 68.3 percent at year-end 2011.   Wholesale internet time deposits decreased to 2.3 percent of deposits from 7.2 percent at year-end 2011 and brokered time deposits decreased to 0.6 percent of deposits from 3.0 percent.

Core deposits, defined as retail and commercial demand, interest bearing demand  (“NOW”), money market and savings accounts, which generally have lower interest costs and management believes are more stable, increased $1.2 million to $216.2 million at September 30, 2012 or 60.0 percent of total deposits from $215.0 million or 54.1 percent of total deposits at year-end 2011.

Because the Consent Order establishes specific capital amounts to be maintained by the Bank, the Bank may not be considered better than “adequately capitalized” for capital adequacy purposes, even if the Bank exceeds the levels of capital set forth in the Consent Order. At September 30, 2012, the Bank’s Tier 1 to average assets ratio and total capital to assets ratio, on a risk adjusted basis, were 7.69 percent and 13.32 percent, respectively. The Bank’s Tier 1 to average assets ratio was below the capital levels required by the Consent Order of 8.00 percent while the Bank’s total capital to assets ratio, on a risk adjusted basis was above the 12.00 percent level required by the Consent Order. As the Bank’s Tier 1 to average assets ratio was below the capital levels required by FDIC and the IDFPR in the Consent Order, the Bank cannot offer brokered CDARS time deposits.  CDARS time deposits issued previously, totaled $2.3 million at September 30, 2012.

 Securities sold under repurchase agreements totaled $19.7 million at September 30, 2012 as compared with $19.5 million at December 31, 2011.  The Company pledges securities for this source of liquidity.  There were $2.3 million in related party repurchase agreements at September 30, 2012 and none at December 31, 2011.

The Company is committed to actively service and maintain its current loan portfolio and is focused on the reduction of its nonperforming assets. As a consequence, the Company expects further declines in loan balances in 2012 due to scheduled principal payments and maturities.

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NORTHERN STATES FINANCIAL CORPORTION

The Company expects deposits to continue to decrease as it further reduces its reliance on wholesale internet time deposits which totaled $8.2 million, and on brokered CDARS time deposits which totaled $2.3 million, at September 30, 2012.  

ASSET QUALITY AND THE PROVISION FOR LOAN AND LEASE LOSSES

At September 30, 2012, management, with the concurrence of the Board of Directors, after carefully reviewing the adequacy of the allowance for loan and lease losses and the levels of nonperforming and impaired loans and leases, determined that an allowance of $16.6 million was adequate to cover potential loan and lease losses.  The Company’s allowance for loan and lease losses to total loans ratio was 5.84 percent at September 30, 2012 compared with 5.88 percent at December 31, 2011.

 During the nine months ended September 30, 2012, a total of $8.6 million in loans and leases were charged-off against the allowance, primarily consisting of $2.6 million of real estate-construction loans and $4.6 million of real estate-mortgage commercial loans, as compared with total charge-offs of $5.8 million during the same period last year.  Recoveries of loans previously charged-off totaled $53,000, as compared with $57,000 in recoveries during the same period in 2011.  For the quarter ended September 30, 2012, the provision for loan and lease losses was $2.1 million as compared with $2.0 million during the same period in 2011 and for the nine months ended September 30, 2012, the provision for loan and lease losses was $6.1 million as compared with $5.7 million during the same period in 2011.

 Nonperforming loans and leases includes 1) loans and leases on nonaccrual status; 2) loans and leases 90 days or more past due and still accruing interest; and 3) accruing loans less than 90 days past due classified as troubled debt restructurings (“TDRs”).  Total nonperforming loans and leases decreased $2.1 million to $69.6 million, or 24.5 percent of total loans and leases, at September 30, 2012 as compared with $71.7 million, or 22.2 percent of total loans and leases, at December 31, 2011.

The $2.1 million decrease to nonperforming loans from year-end 2011 was the result of $8.6 million in loan charge-offs, $4.2 million in loans transferred to other real estate owned  through or in lieu of foreclosure and was partially offset by $10.7 million in net additions to nonperforming loans. During the nine months ended September 30, 2012, the net additions to nonperforming loans were primarily due to five loan relationships totaling $22.5 million placed on nonperforming status of which $12.7 million were real estate-construction loans and $9.8 million secured by commercial real estate.  During this same time period, four loan relationships totaling $16.3 million primarily secured by commercial real estate and apartment buildings were taken off of nonperforming status as the customers proved their ability to service their notes in a timely and sustained fashion.

Nonaccrual loans decreased $1.3 million to $18.2 million at September 30, 2012 from year-end 2011.  This decline in nonaccrual loans was due to charge-offs and transfers to other real estate owned of approximately $8.5 million and $4.2 million, respectively of nonaccrual loans.  This decline was offset by net loans of $11.4 million placed on nonaccrual status.  The Company is attempting to work with the nonaccrual borrowers to resolve their issues, but in many cases where the loans are collateralized by real estate, the Company may have to foreclose on the properties securing the loans and transfer the collateral to other real estate owned.

Loans 90 days or more past due, still accruing totaled $2.4 million at September 30, 2012, an increase of $1.9 million from year-end 2011 due primarily to a construction loan totaling $1.2 million which became 90 days past due since year-end 2011.  Loans 90 days or more past due, still accruing at September 30, 2012, were considered both well secured and in the process of collection.

TDRs decreased $2.8 million to $49.1 million at September 30, 2012 from year-end 2011. Restructuring of loans is undertaken to improve the likelihood that the loan will be repaid in full under the modified terms in accordance with a reasonable repayment schedule. All restructured loans are evaluated to determine whether the loans should be reported as a TDR. A loan is a TDR when the Company, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower by modifying or renewing a loan that the Company would not otherwise consider. To make this determination the Bank must determine whether (a) the borrower is experiencing financial difficulties and (b) the Company granted the borrower a concession and (c) absent the current modification, would the borrower more than likely default.  Factors to consider in determining whether the Company has granted a concession include: lowering the interest rate, extending the maturity date, forgiving debt, reducing accrued interest or changing the payment to interest only for an extended period of time. This determination requires consideration of all of the facts and circumstances surrounding the modification. An overall general decline in the economy or some deterioration in a borrower’s financial condition does not automatically mean the borrower is experiencing financial difficulties.

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NORTHERN STATES FINANCIAL CORPORTION

The Company considers a loan impaired if full principal and interest is not expected to be collected under the contractual terms of the original note.  Nonaccrual loans and accruing TDR loans are classified as impaired.  Impaired loans at September 30, 2012 totaled $68.5 million, as compared with $71.2 million at December 31, 2011, a decrease of $2.7 million. Each impaired loan is individually evaluated for impairment and is carried at the lower of the loan balance or the present value of expected cash flows discounted at the loan's effective interest rate or at the fair value of the collateral less estimated costs to sell if the loan or lease is collateral dependent.  At September 30, 2012, $8.9 million of the allowance for loan and lease losses was allocated to impaired loans.

Management continues to emphasize the early identification of loan-related problems and remains aggressive in pursuing resolution strategies.  The Company has adopted a more stringent and disciplined loan underwriting policy in regards to relationship size and out of market credits.  The Company continues to be an active lender for its current customers as well as other qualifying prospective loan customers.

Total nonperforming real estate-mortgage commercial, real estate-mortgage 5+ family and real estate-mortgage 1-4 family loans decreased $4.8 million, $2.6 million and $2.0 million, respectively, at September 30, 2012 as compared with December 31, 2011 while nonperforming real estate-construction loans increased $7.4 million.

Total nonperforming real estate-mortgage commercial loans decreased $4.8 million during the nine months ended September 30, 2012 primarily due to $11.3 million in loans being placed back on performing status.  Loans totaling $4.6 million were charged-off to the allowance for loan and lease losses while $1.2 million were transferred to other real estate owned.  Loans totaling $12.3 million were placed on nonperforming status including one loan relationship of $7.2 million which was placed on nonaccrual status and another relationship of $2.6 million that became a TDR loan.

Total nonperforming real estate-mortgage 5+ family loans decreased $2.6 million during the nine months ended September 30, 2012 primarily due to $4.0 million in loans being placed back on performing status while $1.2 million in loans were placed on nonperforming status.

Total nonperforming real estate-mortgage 1-4 family loans decreased $2.0 million during the nine months ended September 30, 2012 primarily due to $1.0 million of loans being placed back on performing status.  Real estate-mortgage 1-4 family loans totaling $198,000 were charged-off to the allowance for loan and lease losses while $1.4 million of loans were transferred to other real estate owned.

Offsetting a portion of the decreases to nonperforming loans were increases to nonperforming construction loans of $7.4 million since year-end primarily due to three loan relationships totaling $12.7 million being placed on TDR status.  During the first nine months of 2012, $2.6 million of construction loans were charged-off while $1.5 million were transferred to other real estate owned.

Another component of nonperforming assets is other real estate owned, consisting of assets acquired through or in lieu of foreclosure.  At September 30, 2012, other real estate owned totaled $12.8 million, a decrease of $6.5 million from $19.3 million at December 31, 2011.  The decrease in other real estate owned was due to sales of properties carried at $6.8 million in which the Company recognized losses of $194,000 and to write-downs of $3.9 million taken during the nine months ended September 30, 2012 partially offset by additions of $4.2 million.

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NORTHERN STATES FINANCIAL CORPORTION

The Company’s other real estate owned portfolio at September 30, 2012, consisted primarily of commercial real estate and vacant land of $6.3 million and $3.8 million, respectively.  Other real estate owned also included $1.5 million of 1-4 family homes and $1.2 million of 5 plus family units.  The Company is actively marketing all of its other real estate owned properties for sale.

The fair value of other real estate owned is reviewed by management at least quarterly to help ensure the reasonableness of its carrying value, which is lower of cost or the fair value less estimated selling costs.    If values continue to deteriorate, the Company may have future additional write-downs to its other real estate owned portfolio.

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NORTHERN STATES FINANCIAL CORPORTION

TABLE 1

NORTHERN STATES FINANCIAL CORPORATION

NONPERFORMING LOANS

($ 000s)

					Troubled Debt
			90 Days or		Restructured		Total Non-		% Non-
Nonperforming loans	Nonaccrual		More Past Due,		Loans,		performing		performing
at September 30, 2012	Loans		Still Accruing		Still Accruing		Loans		Loans
Commercial	$	21	$	23	$	102	$	146		0.2	%
Real estate-construction		235		1,248		12,896		14,379		20.6	%
Real estate-mortgage 1-4 family		531		497		2,095		3,123		4.5	%
Real estate-mortgage 5+ family		0		598		700		1,298		1.9	%
Real estate-mortgage commercial		16,005		0		33,258		49,263		70.7	%
Home equity		1,397		31		0		1,428		2.1	%
Leases		0		0		0		0		0.0	%
Installment		0		0		0		0		0.0	%
Total	$	18,189	$	2,397	$	49,051	$	69,637		100.0	%

					Troubled Debt
			90 Days or		Restructured		Total Non-		% Non-
Nonperforming loans	Nonaccrual		More Past Due,		Loans,		performing		performing
at December 31, 2011	Loans		Still Accruing		Still Accruing		Loans		Loans
Commercial	$	548	$	0	$	108	$	656		0.9	%
Real estate-construction		4,447		152		2,428		7,027		9.8	%
Real estate-mortgage 1-4 family		1,263		0		3,901		5,164		7.2	%
Real estate-mortgage 5+ family		3,987		0		0		3,987		5.6	%
Real estate-mortgage commercial		8,772		0		45,301		54,073		75.4	%
Home equity		443		322		0		765		1.1	%
Leases		0		0		0		0		0.0	%
Installment		0		16		0		16		0.0	%
Total	$	19,460	$	490	$	51,738	$	71,688		100.0	%

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NORTHERN STATES FINANCIAL CORPORTION

TABLE 2

NORTHERN STATES FINANCIAL CORPORATION

OTHER REAL ESTATE OWNED

($ 000's)

	September 30,		December 31,
	2012		2011
Real estate - vacant land	$	3,800	$	2,212
Real estate - 1-4 family		1,507		1,834
Real estate - 5+ family		1,179		6,565
Real estate - commercial		6,306		8,731
Total other real estate owned	$	12,792	$	19,342

	Nine months ended
	September 30,			September 30,
	2012			2011
Balance beginning of the period	$	19,342		$	24,326
Additions		4,175			8,128
Sales proceeds		(6,641	)		(7,998	)
Lease-purchase option payments		(35	)		0
Gains (losses) on sales		(194	)		12
Write-downs		(3,855	)		(2,125	)
Balance at end of period	$	12,792		$	22,343

 CAPITAL RESOURCES

Total stockholders’ equity decreased $7.1 million to $21.4 million at September 30, 2012 as compared with $28.5 million at year-end 2011.  The Company’s net loss of $7.4 million and accrual for dividends on the preferred stock of $736,000 for the nine months ended September 30, 2012 were offset by a $924,000 increase to accumulated other comprehensive income relating to the unrealized gains on securities available for sale, net of deferred tax, and $81,000 due to the accretion of the unearned portion of stock awards.  The book value of the Company’s outstanding common stock at September 30, 2012 was $.97 per share, compared with $2.65 at December 31, 2011.

On a consolidated basis, the Company’s Tier 1 to average assets ratio and total capital to assets ratio, on a risk adjusted basis, were 6.13 percent and 12.01 percent, respectively, at September 30, 2012.  The Bank’s Tier 1 to average assets ratio and total capital to assets ratio, on a risk adjusted basis, were 7.69 percent and 13.32 percent, respectively, as of September 30, 2012. The Bank’s Tier 1 to average assets ratio was below the capital levels required by the Consent Order of 8.00 percent while the Bank’s total capital to assets ratio, on a risk adjusted basis, was above the 12.00 percent level required by the Consent Order.  As required by the new Consent Order, management will develop a written capital plan detailing the steps the Bank will take to comply with the minimum capital requirements.

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NORTHERN STATES FINANCIAL CORPORTION

In January 2011, 207,500 shares of restricted stock were issued pursuant to the 2009 Restricted Stock Plan from the Company’s treasury stock.  During 2011 and during the nine months ended September 30, 2012, employees forfeited 9,000 shares of restricted stock, which were returned to treasury stock lowering the total shares issued pursuant to the Plan to 198,500 shares.  During the nine months ended September 30, 2012, 10,500 shares issued to employees vested.  A total of 108,000 restricted stock shares granted to employees of the Company will fully vest in January 2013. Of the 80,000 shares issued to directors, 70,000 shares vested during the first quarter of 2011, while the remaining 10,000 shares fully vest in January 2013.  The expense attributable to these restricted stock awards recognized during the three months ended September 30, 2012 and 2011 totaled $20,000 and $29,000, respectively. The expense attributable to these restricted stock awards recognized during the nine months ended September 30, 2012 and 2011 totaled $79,000 and $210,000, respectively.

LIQUIDITY

The Company’s liquidity is measured by the ability to raise funds through deposits, borrowed funds, capital or cash flow from the repayment or maturities of loans and securities and net profits.   Liquidity is primarily managed through deposits and liquid assets such as cash and due from banks less any reserve requirements, securities available for sale less any pledged securities and federal funds sold.  Asset and liability management is the process of managing the balance sheet to achieve a mix of earning assets and liabilities in such a way that achieves an interest rate risk profile acceptable to management and assists in achieving a desired level of profitability.  An important part of the overall asset and liability management process is providing adequate liquidity.  The Company’s liquid assets consisting of cash and cash equivalents less any Federal Reserve Bank deposit requirements and normal branch cash reserves plus unpledged securities available for sale totaled $67.7 million at September 30, 2012, increasing $6.5 million as compared with $61.2 million at December 31, 2011.

As required by the Consent Order, management developed a liquidity plan that identifies the sources of liquid assets available to meet the Bank’s contingency funding needs over the next twelve months.  This liquidity plan looks at the Bank’s ability to meet the cash flow requirements of customers and other operating needs and seeks to manage liquidity to meet these requirements.  The Company needs to have sufficient cash flow to meet borrowers’ needs to fund loans or the requirements of depositors wanting to withdraw funds.  For the nine months ended September 30, 2012, cash and cash equivalents increased by $3.4 million to $41.2 million as compared with $37.8 million at December 31, 2011.

The Bank’s liquidity plan considers the liquidity provided by scheduled principal payments by borrowers and estimated principal reductions on mortgage-backed securities. The Bank expects to receive liquidity from net loan principal payments by borrowers of approximately $18.2 million and scheduled principal reductions on mortgage-backed securities of approximately $11.2 million over the next twelve months.

 As part of the liquidity policy, management reviews the Bank’s on-balance sheet liquidity ratio as a percentage of deposits weekly.  The on-balance sheet liquidity ratio is the net liquid assets divided by total deposits.  At September 30, 2012, this internally calculated ratio at the Bank was 18.8 percent as compared with 18.2 percent at year-end 2011.

Interest bearing deposits in financial institutions with maturities less than 90 days are a component of the Company’s cash and cash equivalents.  These funds totaled $36.7 million at September 30, 2012 as compared with $32.5 million at December 31, 2011.

The Company classifies all of its securities as available for sale, which increases the Company's flexibility in that the Company can use unpledged securities to meet liquidity requirements by selling the unpledged securities or by increasing its repurchase agreement balances.  Securities available for sale totaled $81.6 million at September 30, 2012, of which $51.1 million were pledged to secure public deposits and repurchase agreements.  At December 31, 2011, securities available for sale totaled $87.1 million of which $57.0 million were pledged.

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NORTHERN STATES FINANCIAL CORPORTION

Another source of liquidity to the Company is deposits. Under the Consent Order, the Bank must limit its brokered time deposits. As a result of the Consent Order, the Bank is not permitted to pay a rate of interest on deposit products that is more than 75 basis points above the rate applicable to the applicable market of the Bank as determined by the FDIC.  The FDIC has recognized that the Bank is operating in a high rate area, which allows the Bank to use local average deposit rates as a basis for setting competitive rates on its deposits.  However, it is expected that total deposits will continue to decline during the balance of 2012 and liquidity available from deposits will be limited. Combined wholesale internet time deposits and brokered time deposits decreased $29.9 million from year-end 2011 to $10.5 million at September 30, 2012 and the Company expects that these deposit types will continue to decrease.

An additional source of liquidity is a line of credit available at the Federal Home Loan Bank of Chicago, which was $16.1 million at September 30, 2012.  There were no outstanding balances on this line of credit at either September 30, 2012 or December 31, 2011.  At September 30, 2012, the Company has pledged loans totaling $29.4 million as security for this line.

The Consent Order also restricts payments of dividends from the Bank to the Company and as such conserves liquidity and capital at the Bank.  Dividends from the Bank are needed to fund dividend payments by the Company to its preferred and common stockholders and the interest payments on its subordinated debentures.   The Written Agreement between the Company and the Federal Reserve Bank dated March 17, 2011, prohibits the Company form paying dividends on its Series A Preferred Stock issued under the TARP Capital Purchase Program.  Due to these constraints, it is expected that the Company will continue to suspend dividend payments on its Series A Preferred Stock and will not pay any dividends to common stockholders in 2012.  Also, the Company will continue to defer interest payments on its subordinated debentures.  At September 30, 2012, the accumulated dividends payable on the Series A Preferred Stock totaled $2.9 million and the cumulative deferred interest payments payable on the subordinated debentures totaled $937,000.

RESULTS OF OPERATIONS

NET INCOME

The Company recognized a loss available to common stockholders for the quarter ended September 30, 2012 of $2.4 million, as compared with a loss of $2.0 million for the same quarter of 2011.  The loss during the third quarter of 2012 was primarily due to a provision to the allowance for loan and lease losses of $2.1 million and, write-downs to other real estate owned of $1.2 million.  The loss for the same quarter of 2011 was primarily the result of provision to the allowance for loan and lease losses of $2.0 million, write-downs to other real estate owned of $797,000.

For the nine months ended September 30, 2012, the Company’s loss available to common stockholders totaled $8.3 million as compared with a loss of $5.9 million for the same period of 2011.  The loss during the nine months ended September 30, 2011 was primarily due to provisions to the allowance for loan and lease losses of $6.1 million and write-downs to other real estate owned of $3.9 million.  During the same nine months of 2011 the Company recognized $5.7 million in provisions to the allowance for loan and lease losses and $2.1 million of write-downs to other real estate owned.

NET INTEREST INCOME

Net interest income, the difference between interest income on earning assets and interest expense on interest bearing liabilities, decreased 16.0 percent or $727,000, and totaled $3.8 million for the quarter ended September 30, 2012  as compared with $4.5 million for the same quarter of 2011.  The major factor causing the decrease to net interest income for the quarter was a decrease in average interest earning assets of $74.7 million as compared with the same quarter of 2011.  Most of the decline to average interest earning assets was due to transfers of loans to other real estate owned, loan payments and payoffs and charge-offs of uncollectible loans to the allowance for loan and lease losses.    Net interest income for the third quarter of was also impacted by the reversal of $238,000 of loan interest income as loans were placed on nonaccrual status compared with only $183,000 of reversed loan interest during the same quarter of 2011.

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NORTHERN STATES FINANCIAL CORPORTION

The net interest spread, the difference between rates earned on interest earning assets and paid on deposits and borrowings for the quarter ended September 30, 2012 increased by 3 basis points to 3.71 percent as compared with 3.68 percent for the same quarter last year.  Yields on interest earning assets declined 22 basis points during the third quarter of 2012 to 3.98 percent from 4.20 percent for the same quarter last year while rates paid on interest bearing liabilities declined 25 basis points.  The decline in rates paid on interest bearing liabilities was primarily due to rates paid on time deposits that decreased 30 basis points as the Company lowered rates offered on its deposit products from last year.

Net interest income for the nine months ended September 30, of 2012, declined $1.6 million or 11.4 percent as compared with the same nine months of 2011 as average interest earning assets decreased $69.9 million due to $69.7 million of decreases to loans.  The net interest spread increased 19 basis points to 3.84 percent during as compared with 3.65 percent for the same period last year.  Yields on interest earning assets declined 11 basis points while rates paid on interest bearing liabilities decreased 30 basis points.

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NORTHERN STATES FINANCIAL CORPORTION

TABLE 3

NORTHERN STATES FINANCIAL CORPORATION

ANALYSIS OF AVERAGE BALANCE AND TAX EQUIVALENT RATES

For the Three Months Ended  September 30, 2012 and 2011 - Rates are Annualized

($ 000s)

			2012							2011
	Average							Average
	Balance		Interest		Rate			Balance		Interest		Rate
Assets
Loans (1)(2)(3)	$	284,502	$	3,527		4.96	%	$	366,419	$	4,519		4.93	%
Taxable securities (4)		81,118		483		2.47	%		87,999		523		2.41	%
Tax advantaged securities (2) (4)		2,989		45		6.28	%		3,864		55		5.76	%
Federal funds sold and other		44,453		28		0.25	%		29,439		13		0.18	%
Interest earning assets		413,062		4,083		3.98	%		487,721		5,110		4.20	%
Noninterest earning assets		18,313							17,486
Total average assets	$	431,375						$	505,207
Liabilities and stockholders' equity
Interest bearing - demand deposits	$	63,417	$	16		0.10	%	$	60,612	$	34		0.22	%
Money market deposits		53,802		7		0.05	%		50,941		38		0.30	%
Savings deposits		71,537		2		0.01	%		66,514		8		0.05	%
Time deposits		114,250		138		0.48	%		189,981		370		0.78	%
Other borrowings		28,943		64		0.88	%		32,542		71		0.87	%
Interest bearing liabilities		331,949		227		0.27	%		400,590		521		0.52	%
Demand deposits		66,856							66,017
Other noninterest bearing liabilities		8,691							6,125
Stockholders' equity		23,879							32,475
Total average liabilities and stockholders' equity	$	431,375						$	505,207
Net interest income			$	3,856						$	4,589
Net interest spread						3.71	%						3.68	%
Net yield on interest earning assets (4)						3.76	%						3.77	%
Interest-bearing liabilities to earning assets ratio						80.36	%						82.14	%

(1) - Interest income on loans includes loan origination and other fees of $49,000 and ($6,000) for the three months ended September 30, 2012 and 2011, respectively.

(2) - Tax-exempt income is reflected on a fully tax equivalent basis utilizing a 34 percent tax rate. The tax equivalent adjustment reflected in the above table for municipal loans is approximately $25,000 and $27,000 for the three months ended September 30, 2012 and 2011, respectively.  The tax equivalent adjustment reflected in the above table for municipal securities is approximately $15,000 and $19,000 for the three months ended September 30, 2012 and 2011, respectively.

(3) - Non-accrual loans are included in average loans.

(4) - Rate information was calculated on the average amortized cost for securities.  The three months ended September 30, 2012 and 2011 average balance information includes an average unrealized gain for taxable securities of $2,983,000 and $1,066,000 and for tax-advantaged securities of $125,000 and $45,000, respectively.

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NORTHERN STATES FINANCIAL CORPORTION

TABLE 4

NORTHERN STATES FINANCIAL CORPORATION

ANALYSIS OF AVERAGE BALANCE AND TAX EQUIVALENT RATES

For the Nine Months Ended  September 30, 2012 and 2011 - Rates are Annualized

($ 000s)

			2012							2011
	Average							Average
	Balance		Interest		Rate			Balance		Interest		Rate
Assets
Loans (1)(2)(3)	$	304,028	$	11,569		5.07	%	$	373,741	$	14,104		5.03	%
Taxable securities (4)		82,996		1,477		2.44	%		88,223		1,632		2.44	%
Tax advantaged securities (2) (4)		3,109		137		6.10	%		3,892		165		5.76	%
Federal funds sold and other		36,409		65		0.24	%		30,543		47		0.21	%
Interest earning assets		426,542		13,248		4.17	%		496,399		15,948		4.28	%
Noninterest earning assets		18,531							22,538
Total average assets	$	445,073						$	518,937
Liabilities and stockholders' equity
Interest bearing - demand deposits	$	63,625	$	76		0.16	%	$	60,674	$	104		0.23	%
Money market deposits		53,246		55		0.14	%		50,543		117		0.31	%
Savings deposits		70,949		12		0.02	%		66,178		29		0.06	%
Time deposits		125,746		503		0.53	%		201,911		1,463		0.97	%
Other borrowings		27,795		202		0.97	%		35,500		237		0.89	%
Interest bearing liabilities		341,361		848		0.33	%		414,806		1,950		0.63	%
Demand deposits		69,010							64,569
Other noninterest bearing liabilities		8,437							6,387
Stockholders' equity		26,265							33,175
Total average liabilities and stockholders' equity	$	445,073						$	518,937
Net interest income			$	12,400						$	13,998
Net interest spread						3.84	%						3.65	%
Net yield on interest earning assets (4)						3.90	%						3.75	%
Interest-bearing liabilities to earning assets ratio						80.03	%						83.56	%

(1) - Interest income on loans includes loan origination and other fees of $119,000 and $39,000 for the nine months ended September 30, 2012 and 2011, respectively.

(2) - Tax-exempt income is reflected on a fully tax equivalent basis utilizing a 34 percent tax rate. The tax equivalent adjustment reflected in the above table for municipal loans is approximately $75,000 and $83,000 for the nine months ended September 30, 2012 and 2011, respectively.  The tax equivalent adjustment reflected in the above table for municipal securities is approximately $46,000 and $56,000 for the nine months ended September 30, 2012 and 2011, respectively.

(3) - Non-accrual loans are included in average loans.

(4) - Rate information was calculated on the average amortized cost for securities.  The nine months ended September 30, 2012 and 2011 average balance information includes an average unrealized gain (loss) for taxable securities of $2,357,000 and ($888,000) and for tax-advantaged securities of $115,000 and $71,000, respectively.

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NORTHERN STATES FINANCIAL CORPORTION

NONINTEREST INCOME

 Noninterest income for the three months ended September 30, 2012 was $955,000 as compared to $1.1 million for the three months ended September 30, 2011, a decrease of $148,000.  Noninterest income decreased as the Company had no sales of securities during the third quarter of 2012 while it sold $19.6 million of securities during the same quarter of 2011 to diversify the underlying collateral of the securities and recognized net gains of $135,000.  Lower service fees on deposits and trust income of $29,000 and $44,000 was mostly offset by increases to gains on sales of other real estate owned and other noninterest income of $36,000 and 24,000, respectively.

For the nine months ended September 30, 2012, the Company recognized noninterest income of $2.7 million as compared to $3.0 million for the same period last year, a decrease of $274,000.  During the nine months ended September 30, 2012, the Company had no gains on sales of securities while during the same period of 2011 the Company recognized gains of $277,000 from sales of $19.6 million of securities. For the nine months ended September 30, 2012 the Company had lower service fees on deposits and trust income of $54,000 and $123,000 compared with the same period of 2011. During 2012, the Company had no impairment of securities or loss on asset sales compared with impairment of securities of $163,000 and loss on asset sales of $38,000 last year.  During nine months ended September 30, 2012, the Company had $194,000 in net losses on sales of $6.8 million of other real estate owned while in the same period of 2011 the Company recognized net gains of $12,000 on sales of $8.0 million of other real estate owned.  Other operating income increased $185,000 primarily due to $142,000 more in ATM and debit card fees.

Effective September 28, 2012, the Bank sold and transferred its designated trust accounts to Thomasville National Bank of Thomasville, Georgia. The Bank recognized no gain or loss on this sale but will receive, in future years, a portion of revenues from these trust assets and any additional local trust business.  Thomasville National Bank will operate the trust business through its subsidiary, NorStates Wealth Management Company.  The effect of this sale on the Company’s short-term future income is expected to be immaterial as the decreased revenues will be largely offset by decreased operating expenses.  It is expected that future income from this revenue sharing agreement will increase due to Thomasville National Bank’s expertise in the trust business.  The Company’s receipt of its share of future trust revenues will be reported as other operating income.

NONINTEREST EXPENSE

Noninterest expense for the quarter ended September 30, 2012 was $4.7 million, decreasing $592,000 from $5.3 million for the same quarter last year.  Noninterest expense decreased primarily due to other real estate owned expenses being $649,000 less during the third quarter of 2012 compared with the same quarter of 2011 as other real estate declined by $6.5 million from year-end 2012.  Another factor was that rental income on other real estate owned which is netted from other real estate owned expenses increased $246,000 from the same quarter last year.   Salaries and other benefits for the quarter ended September 30, 2012 were $220,000 less than for the same quarter last year as the number of Company employees declined to 113 at September 30, 2012 from 124 at September 30, 2011 as the Company reduced its hours and employees left or retired.  Loan and collection expense was $73,000 less for the quarter as last year the Company brought current unpaid real estate taxes on properties securing impaired loans to maintain the Company’s collateral position.  These decreases to the quarter’s noninterest expense were partially offset by increases of $363,000 to the write-down of other real estate owned as the Company continues to monitor the values of these properties in light of a weak real estate market.

For the nine months ended September 30, 2012, the Company had noninterest expense of $16.3 million as compared with $16.2 million for the same nine months of 2011, an increase of $116,000. The increase to noninterest expense was primarily attributable to increased write-downs to other real estate owned which were $1.7 million higher during the nine months ended September 30, 2012 as compared with the same period last year.  Data processing expense also increased $224,000 due to implementation costs in connection with a conversion to a new item processing service provider.  It is expected that future data processing expense will be reduced due to this conversion. Offsetting the increases were declines to loan and collection expense, other real estate owned expense and salaries and employee benefits of $554,000, $514,000 and $321,000, respectively.  Occupancy expense decreased $215,000 as maintenance costs were contained and utilities expense decreased.  FDIC insurance expense declined $209,000 due to changes to the FDIC assessment base.

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NORTHERN STATES FINANCIAL CORPORTION

FEDERAL AND STATE INCOME TAXES

The Company recognized no income tax benefit for the three months ended September 30, 2012 and 2011 despite having a pretax loss of $2.1 million and $1.7 million, respectively.  Per accounting rules, the Company continued to book tax benefits adjusted for timing differences as a deferred tax asset with a corresponding offset to the deferred tax asset valuation allowance, without recognizing a tax benefit on the income statement due to uncertainties as to the realization of these benefits.  For the three months ended September 30, 2012 and 2011, the Company’s tax benefit was calculated to be $858,000 and $697,000.   Similarly, for the nine months ended September 30, 2012 and 2011 the Company had pretax loss of $7.4 million and $5.1 million, respectively, and recognized no income tax benefit, although the calculated tax benefit was $3.1 million and $2.1 million, respectively.  At September 30, 2012, the Company had a net deferred tax asset, exclusive of the deferred tax liability related to the unrealized gain on securities available for sale, of $21.5 million that was offset by a deferred tax asset valuation allowance for the same amount.

REGULATORY MATTERS

On March 17, 2011, the Company and the Federal Reserve Bank entered into a Written Agreement. Pursuant to the Written Agreement, among other things, the Company has agreed to: (i) serve as a source of strength to the Bank; (ii) abstain from paying any dividends, redeeming any stock or incurring any debt without Federal Reserve approval; (iii) adopt a capital plan; (iv) provide the Federal Reserve with cash flow projections on a quarterly basis; (v) notify the Federal Reserve of the proposed addition of any individual to the Board of Directors or the employment of any individual as a senior executive officer of the Company before such addition or employment becomes effective; and (vi) provide progress reports to the Federal Reserve concerning the Company’s compliance with the Written Agreement.

Prior to the Written Agreement, the Company adopted a Board Resolution dated November 17, 2009 which the Written Agreement superseded. The Board Resolution required that the Company obtain written approval from the Federal Reserve prior to: (i) paying dividends to common or preferred stockholders (ii) increasing holding company level debt or subordinated debentures issued in conjunction with trust preferred securities obligations (iii) paying interest on subordinated debentures or (iv) repurchasing Company stock.

In November 2009, in response to the Board Resolution, the Company notified the U.S. Treasury Department (“Treasury”) of its intent to suspend its dividend payments on its Fixed Rate Cumulative Perpetual Preferred Stock, Series A (“Series A Preferred Stock”). The suspension of the dividend payments is permissible under the terms of the Troubled Asset Relief Program Capital Purchase Program, but the dividend is a cumulative dividend and failure to pay dividends for six dividend periods triggers board of director appointment rights for the holder of the Series A Preferred Stock. At September 30, 2012, the Company had suspended twelve dividend payments and has a payable of $2.6 million for the preferred stock dividends. The Company expects that the Treasury Department will appoint one director to its board in 2012.  In January 2011, the Company agreed to allow a Treasury Department observer to attend its board of directors meetings. While dividends are being deferred on the preferred stock issued under the TARP CPP, the Company may not pay dividends on its common stock.

In November 2009, the Company notified the trustee that holds the Company’s junior subordinated debentures relating to its trust preferred securities that the Company would be deferring its regularly scheduled quarterly interest payments. The Company has the right to defer the payment of interest on the junior subordinated debentures at any time, for a period not to exceed 20 consecutive quarters. At September 30, 2012, the Company had deferred payment of twelve regularly scheduled quarterly interest payments and has a payable of $872,000 for the interest on the subordinated debentures. During the deferral period, the Company may not pay any dividends on its common or preferred stock.

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NORTHERN STATES FINANCIAL CORPORTION

On April 16, 2010 the Bank and the FDIC and the IDFPR entered into a joint Consent Order. The Consent Order requires, among other things, increased Bank Board of Directors oversight, certain minimum capital levels, action plans to reduce and manage its classified assets and no payments of dividends without prior approval from its regulators (see Note 8).

The Consent Order requires the Bank to maintain Tier 1 capital to average assets at a minimum of 8.00% and total capital to risk weighted assets at a minimum of 12.00%.  The Bank’s Tier 1 to average assets ratio of 7.69% at September 30, 2012 was below the capital levels required by the Consent Order while the Bank’s total capital to assets ratio of 13.32%, on a risk adjusted basis was above the level required by the Consent Order. Under the Consent Order the Bank may not be considered "well capitalized" for capital adequacy purposes even if it exceeds the levels of capital set forth in the Consent Order.

The Bank has been notified by the FDIC and IDFPR that the Consent Order dated April 16, 2010 will be terminated and the Bank will be required to enter into a new Consent Order.  While the new agreement has not yet been finalized, we expect that it will, among other things, require the Bank to undertake the following:

(1) continued oversight and supervision by the Board of Directors of the Bank and its management, including monitoring compliance with the Consent Order;

(2) maintain a Tier 1 capital to total assets ratio of at least 8% and a total risk-based capital ratio of at least 12%;

(3) provide an updated written capital plan detailing the steps the Bank will take to comply with the minimum capital requirements;

(4) charge- off any loans classified as “loss” and prohibit the extension of additional credit to any existing borrower with a loan that has been previously charged-off or classified “loss”; prohibit the extension of additional credit in excess of $10,000 to any existing borrower with an outstanding loan classified as “substandard,” unless determined by the Board of Directors to be in the best interests of the Bank;

(5) continue to maintain, implement and adhere to written plans to reduce the Bank’s risk position for each classified asset and delinquent loan in excess of $1,000,000, and to manage concentrations of credit, including the ongoing measurement and monitoring and the setting of concentration limits commensurate with the Bank’s capital levels and overall risk profile;

(6) not declare or pay any dividend without the prior consent of the FDIC and IDFPR;

(7) continue to implement its written profit plan and develop a budget that includes the reduction of discretionary expenses and improvement in the Bank’s overall earnings; and

(8) not increase its assets by more than 5% during any three-month period without preapproval, and no more than 15% annually.

For additional information on regulatory matters, see Note 8 and Note 9 in this document in the notes to the interim condensed consolidated financial statements.

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NORTHERN STATES FINANCIAL CORPORTION

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

     The Company’s primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. Interest rate risk is the exposure of a banking organization’s financial condition to adverse movements in interest rates.  The Company seeks to achieve consistent growth in net interest income and net income while managing volatility that arises from shifts in interest rates.  The Company’s Asset and Liability Management Committee (“ALCO”) oversees interest rate risk programs instituted by management and measurements of interest rate risk verifying that they are within authorized limits set by the Company’s Board of Directors.

Evaluating a financial institution’s exposure to changes in interest rates includes assessing both the adequacy of the management process used to control interest rate risk and the organization’s quantitative level of exposure.  When assessing the interest rate risk management process, the Company seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain interest rate risk at prudent levels.  Evaluating the quantitative level of interest rate risk exposure requires the Company to assess the existing and potential future effects of changes in interest rates on its consolidated financial condition, including capital adequacy, earnings, and liquidity.

Proper interest rate risk evaluation must include active board of director and senior management oversight and a comprehensive risk-management process that effectively identifies, measures, and controls interest rate risk.  Several techniques might be used by an institution to minimize interest rate risk.  Such activities fall under the broad definition of asset/liability management.

One approach used by the Company is to periodically analyze the matching of assets and liabilities by examining the extent to which such assets and liabilities are "interest rate sensitive" and by monitoring the Bank's interest rate sensitivity "gap".

An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or reprice within that time period.  The interest rate sensitivity gap is defined as the difference between the amount of interest earning assets maturing or repricing within a specific time period and the amount of interest bearing liabilities maturing or repricing within that same time period.  A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities and a gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets in a given time frame.  During a period of rising interest rates, a negative gap would tend to adversely affect net interest income while a positive gap would tend to result in an increase in net interest income.

Another approach used by management to analyze interest rate risk is to periodically evaluate or “shock” the Company’s base 12- month projected net interest income by assuming an instantaneous decrease or increase in rates using computer simulation.  Table 5 shows this analysis at September 30, 2012 and December 31, 2011.  The computer simulation model used to do the interest rate shocks and calculate the effect on projected net interest income takes into consideration maturity and repricing schedules of the various assets and liabilities as well as call provisions on the Company’s securities.  Current policy set by the Board of Directors limits exposure to net interest income from interest rate shocks.

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NORTHERN STATES FINANCIAL CORPORTION

TABLE 5

NORTHERN STATES FINANCIAL CORPORATION

EFFECT OF INTEREST SHOCKS ON NET INTEREST INCOME

as of September 30, 2012 and December 31, 2011

($000's)

				Immediate Change in Rates
		-2.00	%		-1.00	%		1.00	%		2.00	%
September 30, 2012:
Dollar Change from Base	$	235		$	359		$	(137	)	$	(250	)
Percent Change from Base		1.21	%		1.85	%		-0.71	%		-1.29	%
December 31, 2011:
Dollar Change from Base	$	(12	)	$	298		$	53		$	122
Percent Change from Base		-0.07	%		1.74	%		0.31	%		0.71	%

September 30, 2012, the base forecasted 12-month net interest income decreases $250,000 when rates are shocked upwards 2% while net interest income increases $235,000 for a 2% downwards rate shock.

The Company can manage interest rate risk by selling existing assets, repaying certain liabilities or matching repricing periods for new assets and liabilities.  Financial institutions are subject to prepayment risk in a falling rate environment.  For example, a debtor may prepay financial assets in order to refinance obligations at new, lower rates.  The Company attempts to mitigate this risk by having prepayment penalties on fixed rate loans.  The Company also seeks to mitigate the effect on net interest income from variable rate loans by placing floors whenever possible.  In a rising rate environment financial institutions are subject to early redemption of time deposits.  The Company attempts to mitigate this risk by having prepayment penalties on early redemptions.

Based on the September 13, 2012 monetary policy announcement of the Federal Reserve’s Federal Open Market Committee, it is anticipated that rates will remain at historic lows through mid-2015.

ITEM 4. CONTROLS AND PROCEDURES.

The Company’s management has evaluated, with the participation of the President and Chief Executive Officer, and Vice President and Chief Financial Officer, the Company’s disclosure controls and procedures (as such term is defined in Rule 13a – 15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report.  Based on that evaluation, the President and Chief Executive Officer, and Vice President and Chief Financial Officer, have concluded that these controls and procedures were effective, in all material respects, as of such date.  There were no changes in the Company’s internal control over financial reporting (as such term is defined in Rule 13a – 15(f) under the Securities Exchange Act of 1934) that occurred during the third quarter of 2012 that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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NORTHERN STATES FINANCIAL CORPORTION

PART II. OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS.

From time to time, due to the nature of its business, the Company and its subsidiaries are often subject to various legal actions.  These legal actions, whether pending or threatened, arise through the normal course of business and neither the Company nor any of its subsidiaries are currently involved in any proceedings that would, in management’s judgment, have a material adverse effect on the Company’s business, results of operations, financial condition or cash flows.

ITEM 1A.  RISK FACTORS.

There have been no material changes to the risk factors relating to the Company from those risk factors previously disclosed in the Company’s Annual Report on Form 10-K for its fiscal year ended December 31, 2011 in response to Item 1A. to Part I of Form 10-K.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

None.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES.

 None.

ITEM 4.  MINE SAFETY DISCLOSURES.

Not applicable.

ITEM 5.  OTHER INFORMATION.

 None.

ITEM 6.  EXHIBITS.

(a) Exhibits.

Exhibit 3.1- Certificate of Incorporation of the Company, as amended (incorporated herein by reference to the Company’s Annual Report on Form 10-K for the year ended December 31, 1994 (File No. 000-19300)).

Exhibit 3.2 - Certificate of Amendment of the Certificate of Incorporation of the Company, as amended, dated April 27, 1998 (incorporated herein by reference to Exhibit 3.2 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2008 (File No. 000-19300) filed on March 25, 2009).

Exhibit 3.3 - Certificate of Amendment of the Certificate of Incorporation of the Company, as amended, dated January 20, 2009 (incorporated herein by reference to Exhibit 3.3 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2008 (File No. 000-19300) filed on March 25, 2009).

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NORTHERN STATES FINANCIAL CORPORTION

Exhibit 3.4 - Certificate of Designations of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, dated February 18, 2009 (incorporated herein by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K (File No. 000-19300) filed on February 20, 2009).

Exhibit 3.5 - Amended and Restated By-laws of the Company dated April 20, 2004 (incorporated herein by reference to Exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q (File No. 000-19300) filed on May 10, 2004).

Exhibit 4.1 - Form of Certificate of the Preferred Stock (incorporated herein by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K (File No. 000-19300) filed on February 20, 2009).

Exhibit 4.2 - Warrant to purchase shares of Common Stock (incorporated herein by reference to Exhibit 4.2 to the Company’s Current Report on Form 8-K (File No. 000-19300) filed on February 20, 2009).

Exhibit 11.1 - Statement of Computation of per share earnings. (Contained in Notes 1 and 3 to the condensed consolidated financial statements.)

Exhibit 15.1 - Acknowledgement of Independent Registered Public Accounting Firm.

Exhibit 31.1 - Section 302 Certification of President and Chief Executive Officer.

Exhibit 31.2 - Section 302 Certification of Vice President and Chief Financial Officer.

Exhibit 32.1 - Section 906 Certification.

Exhibit 101.1 - The following financial statements from the Northern States Financial Corporation Quarterly Report on Form 10-Q for the quarter ended September 30, 2012, formatted in Extensive Business Reporting Language (XBRL): (i) condensed consolidated balance sheets, (ii) condensed consolidated statements of operations, (iii) condensed consolidated statements of cash flows, (iv) condensed consolidated statements of stockholders’ equity, and (v) the notes to condensed consolidated financial statements.*

*Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files submitted under Exhibit 101.1 are not deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, or otherwise subject to the liability of that Section.  Such exhibit shall not be deemed incorporated into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934.

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NORTHERN STATES FINANCIAL CORPORATION

FORM 10-Q

September 30, 2012

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report on Form 10-Q to be signed on its behalf by the undersigned thereunto duly authorized.

		NORTHERN STATES FINANCIAL CORPORATION
		(Registrant)
Date	November 8, 2012	By:	/s/ Scott Yelvington
			Scott Yelvington
			President and Chief Executive Officer

Date	November 8, 2012	By:	/s/ Steven Neudecker
			Steven Neudecker
			Vice President and Chief Financial Officer

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NORTHERN STATES FINANCIAL CORPORATION

FORM 10-Q

September 30, 2012

EXHIBIT INDEX

Exhibits

Exhibit 3.1 - Certificate of Incorporation of the Company, as amended (incorporated herein by reference to the Company’s Annual Report on Form 10-K for the year ended December 31, 1994 (File No. 000-19300)).

Exhibit 3.2 - Certificate of Amendment of the Certificate of Incorporation of the Company, as amended dated April 27, 1998 (incorporated herein by reference to Exhibit 3.2 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2008 (File No. 000-19300) filed on March 25, 2009).

Exhibit 3.3 - Certificate of Amendment of the Certificate of Incorporation of the Company, as amended dated January 20, 2009 (incorporated herein by reference to Exhibit 3.3 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2008 (File No. 000-19300) filed on March 25, 2009).

Exhibit 3.4 - Certificate of Designations of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, dated February 18, 2009 (incorporated herein by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K (File No. 000-19300) filed on February 20, 2009).

Exhibit 3.5 - Amended and Restated By-laws of the Company dated April 20, 2004 (incorporated herein by reference to Exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q (File No. 000-19300) filed on May 10, 2004).

Exhibit 4.1 - Form of Certificate of the Preferred Stock (incorporated herein by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K (File No. 000-19300) filed on February 20, 2009).

Exhibit 4.2 - Warrant to purchase shares of Common Stock (incorporated herein by reference to Exhibit 4.2 to the Company’s Current Report on Form 8-K (File No. 000-19300) filed on February 20, 2009).

Exhibit11.1 - Statement of Computation of per share earnings. (Contained in Notes 1 and 3 to the condensed consolidated financial statements.)

Exhibit 15.1 - Acknowledgement of Independent Registered Public Accounting Firm.

Exhibit 31.1 - Section 302 Certification of President and Chief Executive Officer.

Exhibit 31.2 - Section 302 Certification of Vice President and Chief Financial Officer.

Exhibit 32.1 - Section 906 Certification.

Exhibit 101.1 - The following financial statements from the Northern States Financial Corporation Quarterly Report on Form 10-Q for the quarter ended September 30, 2012, formatted in Extensive Business Reporting Language (XBRL): (i) condensed consolidated balance sheets, (ii) condensed consolidated statements of operations, (iii) condensed consolidated sta31.1tements of cash flows, (iv) condensed consolidated statements of stockholders’ equity, and (v) the notes to condensed consolidated financial statements.*

*Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files submitted under Exhibit 101.1 are not deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, or otherwise subject to the liability of that Section.  Such exhibit shall not be deemed incorporated into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934.

54