FAIR VALUE MEASUREMENT AND DISCLOSURE

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined using quoted market prices. However, in many instances, quoted market prices are not available. In such instances, fair values are determined using various valuation techniques. Various assumptions and observable inputs must be relied upon in applying these techniques. GAAP establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.

GAAP permits an entity to choose to measure eligible financial instruments and other items at fair value. The Company has elected the fair value option for its loans held for sale. Electing the fair value option for loans held for sale enables the Company’s financial position to more clearly align with the economic value of the actively traded asset.

The fair value hierarchy for valuation of an asset or liability is as follows:

Level 1: Valuation is based upon unadjusted quoted prices in active markets for identical assets and liabilities that the entity has the ability to access as of the measurement date.

Level 2: Valuation is determined from quoted prices for similar assets or liabilities in active markets, from quoted prices for identical or similar instruments in markets that are not active or by model-based techniques in which all significant inputs are observable in the market.

Level 3: Valuation is derived from model-based and other techniques in which at least one significant input is unobservable and which may be based on the Company’s own estimates about the assumptions that market participants would use to value the asset or liability.

In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon model-based techniques incorporating various assumptions including interest rates, prepayment speeds and credit losses. Assets and liabilities valued using model-based techniques are classified as either Level 2 or Level 3, depending on the lowest level classification of an input that is considered significant to the overall valuation. A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

Financial Instruments Recorded at Fair Value on a Recurring Basis

Securities Available-for-sale: The fair value of debt securities available-for-sale is reported utilizing prices provided by an independent pricing service based on recent trading activity and other observable information including, but not limited to, dealer quotes, market spreads, cash flows, market interest rate curves, market consensus prepayment speeds, credit information, and the bond’s terms and conditions. The fair value of equity securities available-for-sale was calculated using a discounted cash flow analysis using observable information including, but not limited to, cash flows, risk-adjusted discount rates and market spreads. The fair values of debt and equity securities are classified as Level 2.

Trading Account Assets: Trading account assets are invested in mutual funds and classified as Level 1 based upon quoted prices.

Loans Held for Sale: The fair value of loans held for sale is determined using quoted secondary market prices or executed sales agreements and classified as Level 2.

Derivatives: The fair value of interest rate swaps is determined using inputs that are observable in the market place obtained from third parties including yield curves, publicly available volatilities, and floating indexes and, accordingly, are classified as Level 2 inputs. The credit value adjustments associated with derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by the Company and its counterparties. As of June 30, 2013 and December 31, 2012, the Company has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives due to collateral postings.

The following table summarizes financial assets and financial liabilities measured at fair value on a recurring basis as of June 30, 2013 and December 31, 2012, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:



	Readily Available Market Prices (Level 1)		Observable Market Data (Level 2)		Company Determined Fair Value (Level 3)		Total
June 30, 2013
Financial Assets:
Available-for-sale debt securities:
Obligations of states and political subdivisions	$	—	$	30,489	$	—	$	30,489
Mortgage-backed securities issued or guaranteed by U.S. government sponsored enterprises	—		348,778		—		348,778
Collateralized mortgage obligations issued or guaranteed by U.S. government sponsored enterprises	—		402,257		—		402,257
Private issue collateralized mortgage obligations	—		7,845		—		7,845
Trading account assets	2,281		—		—		2,281
Loans held for sale	—		2,826		—		2,826
Customer interest rate swap agreements	—		193		—		193
Financial Liabilities:
Interest rate swap agreements	—		6,437		—		6,437
December 31, 2012
Financial Assets:
Available-for-sale debt securities:
Obligations of states and political subdivisions	$	—	$	33,040	$	—	$	33,040
Mortgage-backed securities issued or guaranteed by U.S. government sponsored enterprises	—		358,148		—		358,148
Collateralized mortgage obligations issued or guaranteed by U.S. government sponsored enterprises	—		381,688		—		381,688
Private issue collateralized mortgage obligations	—		8,174		—		8,174
Trading account assets	2,300		—		—		2,300
Customer interest rate swap agreements	—		496		—		496
Financial Liabilities:
Interest rate swap agreements	—		11,580		—		11,580

The Company did not have any transfers between Level 1 and Level 2 of the fair value hierarchy during the six months ended June 30, 2013. The Company’s policy for determining transfers between levels occurs at the end of the reporting period when circumstances in the underlying valuation criteria change and result in transfer between levels.

Financial Instruments Recorded at Fair Value on a Nonrecurring Basis

The Company may be required, from time to time, to measure certain financial assets and financial liabilities at fair value on a nonrecurring basis in accordance with GAAP. These include assets that are measured at the lower of cost or market value that were recognized at fair value below cost at the end of the period.

Collateral-Dependent Impaired Loans: Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, the Company measures impairment in accordance with GAAP. Impaired loans are measured using one of three methods: the present value of expected future cash flows discounted at the loan’s effective interest rate; the loan’s observable market price; or the fair value of the collateral if the loan is collateral dependent. If the measure is less than an impaired loan’s recorded investment, an impairment loss is recognized as part of the ALL. Accordingly, certain impaired loans may be subject to measurement at fair value on a non-recurring basis. Management has estimated the fair values of these assets using Level 2 inputs, such as the fair value of collateral based on independent third-party market approach appraisals for collateral-dependent loans, and level 3 inputs where circumstances warrant an adjustment to the appraised value based on the age of the appraisal and/or comparable sales, condition of the collateral, and market conditions.

Mortgage Servicing Rights: The Company accounts for mortgage servicing assets at cost, subject to impairment testing. When the carrying value exceeds fair value, a valuation allowance is established to reduce the carrying cost to fair value. Fair value is based on a valuation model that calculates the present value of estimated net servicing income. The Company obtains a third-party valuation based upon loan level data including note rate, type and term of the underlying loans. The model utilizes a variety of observable inputs for its assumptions, the most significant of which are loan prepayment assumptions and the discount rate used to discount future cash flows. Other assumptions include delinquency rates, servicing cost inflation and annual unit loan cost. Mortgage servicing rights are classified within Level 2 of the fair value hierarchy.

Non-Financial Assets and Non-Financial Liabilities Recorded at Fair Value

The Company has no non-financial assets or non-financial liabilities measured at fair value on a recurring basis. Non-financial assets measured at fair value on a non-recurring basis consist of other real estate owned (“OREO”).

OREO properties acquired through foreclosure or deed in lieu of foreclosure are recorded at the fair value of the real estate, less costs to sell. Any write-down of the recorded investment in the related loan is charged to the allowance for loan losses upon transfer to OREO. Upon acquisition of a property, a current appraisal or a broker’s opinion is used to substantiate fair value for the property. After foreclosure, management periodically obtains updated valuations of the OREO assets and, if additional impairments are deemed necessary, the subsequent write-downs for declines in value are recorded through a valuation allowance and a provision for losses charged to other non-interest expense. Certain assets require assumptions, such as expected future cash flows, that are not observable in an active market in determination of fair value and are classified as Level 3.

Assets measured at fair value on a non-recurring basis as of June 30, 2013 and December 31, 2012 are included below:



	Readily Available Market Prices (Level 1)		Observable Market Data (Level 2)		Company Determined Fair Value (Level 3)		Total
June 30, 2013
Assets:
Collateral-dependent impaired loans	$	—	$	—	$	7,998	$	7,998
Other real estate owned	—		—		2,155		2,155
Mortgage servicing rights	—		1,316		—		1,316
December 31, 2012
Assets:
Collateral-dependent impaired loans	$	—	$	—	$	9,183	$	9,183
Other real estate owned	—		—		1,313		1,313
Mortgage servicing rights	—		879		—		879

The following table presents the valuation methodology and unobservable inputs for Level 3 assets measured at fair value on a non-recurring basis at June 30, 2013:



	Fair Value		Valuation Methodology	Unobservable input	Discount Range
June 30, 2013
Collateral-dependent impaired loans: (1)
Partially charged-off	$	3,378	Market approach appraisal of collateral	Management adjustment of appraisal	10 – 30	%
Specifically reserved	$	4,620	Market approach appraisal of collateral	Management adjustment of appraisal	—	(2)
Other real estate owned	$	2,155	Market approach appraisal of collateral	Management adjustment of appraisal	10 – 30	%
				Estimated selling cost	6 – 10	%
December 31, 2012
Collateral-dependent impaired loans:(1)
Partially charged-off	$	3,524	Market approach appraisal of collateral	Management adjustment of appraisal	10 – 30	%
Specifically reserved	$	5,659	Market approach appraisal of collateral	Management adjustment of appraisal	—	(2)
Other real estate owned	$	1,313	Market approach appraisal of collateral	Management adjustment of appraisal	10 – 30	%
				Estimated selling cost	6 – 10	%


(1)	Does not include impaired loans that are measured by the present value of expected future cash flows discounted at the loan’s effective interest rate.


(2)	The specific reserve for collateral-dependent impaired loans is determined by any deficit of 75% of collateral value over the recorded investment.

GAAP requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are discussed above. The following methods and assumptions were used by the Company in estimating the fair values of its other financial instruments.

Cash and Due from Banks: The carrying amounts reported in the consolidated statement of condition approximate fair value.

FHLB and Federal Reserve Bank Stock and Investments in Trust Preferred Securities Affiliates: The carrying amounts reported in the consolidated statements of condition approximate fair value.

Loans: For variable rate loans that reprice frequently and have no significant change in credit risk, fair values are based on carrying values. The fair value of other loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

Interest Receivable and Payable: The carrying amounts reported in the consolidated statements of condition approximate fair value.

Deposits: The fair value of deposits with no stated maturity is equal to the carrying amount. The fair value of certificates of deposit is estimated using a discounted cash flow calculation that applies interest rates and remaining maturities for currently offered certificates of deposit.

Borrowings: The carrying amounts of short-term borrowings from the FHLB, securities sold under repurchase agreements, notes payable and other short-term borrowings approximate fair value. The fair values of long-term borrowings and commercial repurchase agreements are based on the discounted cash flows using current rates for advances of similar remaining maturities.

Junior Subordinated Debentures: The carrying amounts reported in the consolidated statements of condition approximate fair value.

The following table presents the carrying amounts and estimated fair value for financial instrument assets and liabilities measured at June 30, 2013:



	Carrying Amount		Fair Value		Readily Available Market Prices (Level 1)		Observable Market Prices (Level 2)		Company Determined Market Prices (Level 3)
Financial assets:
Cash and due from banks	$	44,896	$	44,896	$	44,896	$	—	$	—
Securities available-for-sale	789,369		789,369		—		789,369		—
FHLB and Federal Reserve Bank stock	19,724		19,724		19,724		—		—
Trading account assets	2,281		2,281		2,281		—		—
Loans held for sale	2,826		2,826		—		2,826		—
Residential real estate loans	561,975		575,594		—		—		575,594
Commercial real estate loans	518,640		508,194		—		—		508,194
Commercial loans	183,059		180,642		—		—		180,642
Home equity loans	297,717		296,968		—		—		296,968
Consumer loans	17,847		18,104		—		—		18,104
Mortgage servicing rights	774		1,316		—		1,316		—
Interest receivable	6,506		6,506		—		6,506		—
Investment in trust preferred securities affiliates	1,331		1,331		—		—		1,331
Customer interest rate swap agreements	193		193		—		193		—
Financial liabilities:
Deposits	1,894,087		1,899,346		1,340,252		559,094		—
FHLB advances	186,147		189,421		—		189,421		—
Commercial repurchase agreements	30,165		32,615		—		32,615		—
Other borrowed funds	188,153		188,153		188,153		—		—
Junior subordinated debentures	43,870		43,845		—		43,845		—
Interest payable	563		563		563		—		—
Interest rate swap agreements	6,437		6,437		—		6,437		—

The following table presents the carrying amounts and estimated fair value for financial instrument assets and liabilities measured at December 31, 2012:



	Carrying Amount		Fair Value		Readily Available Market Prices (Level 1)		Observable Market Prices (Level 2)		Company Determined Market Prices (Level 3)
Financial assets:
Cash and due from banks	$	58,290	$	58,290	$	58,290	$	—	$	—
Securities available-for-sale	781,050		781,050		—		781,050		—
FHLB and Federal Reserve Bank stock	21,034		21,034		21,034		—		—
Trading account assets	2,300		2,300		2,300		—		—
Residential real estate loans	564,184		591,139		—		—		591,139
Commercial real estate loans	501,037		492,602		—		—		492,602
Commercial loans	183,680		179,519		—		—		179,519
Home equity loans	275,498		277,194		—		—		277,194
Consumer loans	16,423		16,866		—		—		16,866
Mortgage servicing rights	542		879		—		879		—
Interest receivable	6,215		6,215		—		6,215		—
Investment in trust preferred securities affiliates	1,331		1,331		—		—		1,331
Customer interest rate swap agreements	496		496		—		496		—
Financial liabilities:
Deposits	1,929,469		1,936,446		1,339,290		597,156		—
FHLB advances	56,404		60,813		—		60,813		—
Commercial repurchase agreements	66,187		69,067		—		69,067		—
Other borrowed funds	193,753		193,753		193,753		—		—
Junior subordinated debentures	43,819		43,819		—		43,819		—
Interest payable	905		905		905		—		—
Interest rate swap agreements	11,580		11,580		—		11,580		—