9. FAIR VALUE

Fair value measurement is determined based on the assumptions that market participants would use in pricing the asset or liability in an exchange. The definition of fair value includes the exchange price which is the price in an orderly transaction between market participants to sell an asset or transfer a liability in the principal market for the asset or liability. Market participant assumptions include assumptions about risk, the risk inherent in a particular valuation technique used to measure fair value and/or the risk inherent in the inputs to the valuation technique, as well as the effect of credit risk on the fair value of liabilities. The Company uses three levels of the fair value inputs to measure assets, as described below.

Basis of Fair Value Measurement:

Level 1 – Valuations based on quoted prices in active markets for identical investments.

Level 2 – Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly. Level 2 inputs include: (i) quoted prices for similar investments in active markets, (ii) quoted prices for identical investments traded in non-active markets (i.e., dealer or broker markets) and (iii) inputs other than quoted prices that are observable or inputs derived from or corroborated by market data for substantially the full term of the investment.

Level 3 – Valuations based on inputs that are unobservable, supported by little or no market activity, and significant to the overall fair value measurement.

The types of instruments valued based on quoted market prices in active markets include most U.S. Treasury securities. Such instruments are generally classified within Level 1 and Level 2 of the fair value hierarchy. The Company does not adjust the quoted price for such instruments.

The types of instruments valued based on quoted prices in markets that are not active, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include U.S. Government agency securities, state and municipal obligations, MBS, CMOs and corporate bonds. Such instruments are generally classified within Level 2 of the fair value hierarchy.

The types of instruments valued based on significant unobservable inputs that reflect the Company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability are generally classified within Level 3 of the fair value hierarchy.

The following table presents the carrying amounts and fair values of the Company’s financial instruments (in thousands).

		June 30, 2016				December 31, 2015
	Level in Fair Value Hierarchy	Carrying Amount		Fair Value		Carrying Amount		Fair Value

Financial Assets:
Cash and due from banks	Level 1	$	130,762	$	130,762	$	98,086	$	98,086
Federal Reserve and Federal Home Loan Bank stock and other investments	Level 2		4,469		4,469		10,756		10,756
Investment securities held to maturity	Level 2		29,466		31,011		61,309		63,272
Investment securities available for sale	Level 2		215,111		215,111		247,099		247,099
Loans held for sale	Level 2		2,790		2,790		1,666		1,666
Loans, net of allowance	Level 2, 3 (1)		1,708,909		1,714,090		1,645,762		1,628,169
Accrued interest and loan fees receivable	Level 2		5,893		5,893		5,859		5,859

Financial Liabilities:
Non-maturity deposits	Level 2		1,723,101		1,723,101		1,555,980		1,555,980
Time deposits	Level 2		225,918		225,927		224,643		224,408
Borrowings	Level 2		15,000		15,258		165,000		164,827
Accrued interest payable	Level 2		186		186		198		198
Derivatives	Level 3		752		752		752		752

(1)

Impaired loans are generally classified within Level 3 of the fair value hierarchy.

Fair value estimates are made at a specific point in time and may be based on judgments regarding losses expected in the future, risk, and other factors that are subjective in nature. The methods and assumptions used to produce the fair value estimates follow.

For securities held to maturity and securities available for sale, the fair value equals quoted market price if available. If a quoted market price is not available, fair value is estimated using a quoted market price for similar securities. For cash and due from banks, federal funds sold, accrued interest and loan fees receivable, non-maturity deposits and accrued interest payable, the carrying amount is a reasonable estimate of fair value due to the short term nature of these instruments. Determining the fair value of Federal Reserve and Federal Home Loan Bank stock and other investments is not practicable due to restrictions placed on its transferability; thus, carrying amount is a reasonable estimate of fair value. Time deposits and borrowings are valued using a replacement cost of funds approach.

Fair values are estimated for portfolios of loans with similar characteristics. The fair value of performing loans was calculated by discounting projected cash flows through their estimated maturity using market discount rates that reflect the general credit and interest rate characteristics of the loan category. The maturity horizon is based on the Company’s history of repayments for each type of loan and an estimate of the effect of current economic conditions. Assumptions regarding credit risk, cash flows, and discount rates are made using available market information and specific borrower information.

Loans identified as impaired are measured using one of three methods: the fair value of collateral less estimated costs to sell, the present value of expected future cash flows or the loan’s observable market price. Those measured using the fair value of collateral or the loan’s observable market price are recorded at fair value. For each period presented, no impaired loans were measured using the loan’s observable market price. If an impaired loan has had a charge-off or if the fair value of the collateral is less than the recorded investment in the loan, the Company establishes a specific reserve and reports the loan as non-recurring Level 3. The fair value of collateral of impaired loans is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

For the periods presented, loans held for sale were performing and carried at cost. The carrying cost is a reasonable estimate of fair value due to their short-term nature.

OREO properties are initially recorded at fair value, less estimated costs to sell when acquired, establishing a new cost basis. Adjustments to OREO are measured at fair value, less estimated costs to sell. Fair values are generally based on third party appraisals or realtor evaluations of the property. These appraisals and evaluations may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less estimated costs to sell, an impairment loss is recognized through a valuation allowance, and the property is reported as non-recurring Level 3. No valuation allowance was recorded for OREO at June 30, 2016.

In conjunction with the sale of Visa Class B shares in 2013, the Company entered into derivative swap contracts with the purchaser of its Visa Class B shares. The fair value of these derivatives is measured using an internal model that includes the use of probability weighted scenarios for estimates of Visa’s aggregate exposure to the litigation matters, with consideration of amounts funded by Visa into its escrow account for this litigation. At June 30, 2016, the Company estimates a fair value for these derivatives at approximately 10% of the net proceeds from the Company’s sale of the related Visa Class B shares. Since this estimation process requires application of judgment in developing significant unobservable inputs used to determine the possible outcomes and the probability weighting assigned to each scenario, these derivatives have been classified as Level 3 within the valuation hierarchy. (See also Note 3. Investment Securities contained herein.)

The fair value of commitments to extend credit is estimated by either discounting cash flows or using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the current creditworthiness of the counter-parties. The estimated fair value of written financial guarantees and letters of credit is based on fees currently charged for similar agreements. The fees charged for the commitments were not material in amount.

Assets measured at fair value on a non-recurring basis are as follows (in thousands):

Assets:	June 30, 2016		Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
Impaired loans	$	3,001	$	3,001
OREO		650		650
Total	$	3,651	$	3,651

Assets:	December 31, 2015		Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
Impaired loans	$	2,715	$	2,715
Total	$	2,715	$	2,715

The Company had no liabilities measured at fair value on a non-recurring basis at June 30, 2016 and December 31, 2015.

The following presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis (dollars in thousands):

	Fair Value at
Assets:	June 30, 2016		December 31, 2015		Valuation Technique	Unobservable Inputs	Discount
Impaired loans:

Commercial and industrial	$	950	$	-	Advance rate against inventory and receivables	Discount to financial statement values	25% to 50		%	(1	)

Residential mortgages		1,784		2,311	Third party appraisal	Discount to appraised value		25	%	(2	)

Home equity		199		280	Third party appraisal	Discount to appraised value		25	%	(2	)

Consumer		68		124	Third party appraisal	Discount to appraised value		25	%	(3	)
Total	$	3,001	$	2,715

OREO	$	650	$	-	Third party appraisal	Estimated holding/selling costs		11	%

(1) The Company makes adjustments based upon evaluation of corporate assets, such as inventory and accounts receivable, and various other information, such as market conditions and other factors. Higher discounts may be applied to certain assets, such as inventory and accounts receivable.

(2) Of which estimated selling costs are approximately 9% - 15% of the total discount.

(3) Of which estimated selling costs are approximately 10% - 12% of the total discount.

The following presents fair value measurements on a recurring basis at June 30, 2016 and December 31, 2015 (in thousands):

			Fair Value Measurements Using
Assets:	June 30, 2016		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
U.S. Government agency securities	$	5,000	$	5,000	$	-
Obligations of states and political
subdivisions		85,396		85,396		-
Collateralized mortgage obligations		19,109		19,109		-
Mortgage-backed securities		96,891		96,891		-
Corporate bonds		8,715		8,715		-
Total	$	215,111	$	215,111	$	-

Liabilities:
Derivatives	$	752	$	-	$	752
Total	$	752	$	-	$	752

			Fair Value Measurements Using
Assets:	December 31, 2015		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
U.S. Government agency securities	$	28,516	$	28,516	$	-
Obligations of states and political subdivisions		104,682		104,682		-
Collateralized mortgage obligations		15,549		15,549		-
Mortgage-backed securities		92,442		92,442		-
Corporate bonds		5,910		5,910		-
Total	$	247,099	$	247,099	$	-

Liabilities:
Derivatives	$	752	$	-	$	752
Total	$	752	$	-	$	752

Reconciliations for assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) follow (in thousands).

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)

	Three Months Ended June 30,				Six Months Ended June 30,
	2016		2015		2016		2015
	Liabilities Derivatives		Liabilities Derivatives		Liabilities Derivatives		Liabilities Derivatives
Beginning balance	$	752	$	752	$	752	$	752
Net change		-		-		-		-
Ending balance	$	752	$	752	$	752	$	752