Note 4.

Allowance for Loan Losses and Credit Quality of Loans

Allowance for Loan Losses

The allowance for loan losses is maintained at a level estimated by management to provide adequately for risk of probable losses inherent in the current loan portfolio. The adequacy of the allowance for loan losses is continuously monitored. It is assessed for adequacy using a methodology designed to ensure the level of the allowance reasonably reflects the loan portfolio’s risk profile. It is evaluated to ensure that it is sufficient to absorb all reasonably estimable credit losses inherent in the current loan portfolio.

To develop and document a systematic methodology for determining the allowance for loan losses, the Company has divided the loan portfolio into three segments, each with different risk characteristics and methodologies for assessing risk. Those segments are further segregated between our loans accounted for under the amortized cost method (referred to as “originated” loans) and loans acquired in a business combination (referred to as “acquired” loans). Each portfolio segment is broken down into class segments where appropriate. Class segments contain unique measurement attributes, risk characteristics and methods for monitoring and assessing risk that are necessary to develop the allowance for loan losses. Unique characteristics such as borrower type, loan type, collateral type, and risk characteristics define each class segment. The following table illustrates the portfolio and class segments for the Company’s loan portfolio:

Portfolio	Class
Commercial Loans	Commercial
	Commercial Real Estate
	Agricultural
	Agricultural Real Estate
	Business Banking

Consumer Loans	Indirect
	Home Equity
	Direct

Residential Real Estate Mortgages

Commercial Loans

The Company offers a variety of commercial loan products including commercial (non-real estate), commercial real estate, agricultural, agricultural real estate, and business banking loans. The Company’s underwriting analysis for commercial loans typically includes credit verification, independent appraisals, a review of the borrower’s financial condition, and a detailed analysis of the borrower’s underlying cash flows.

Commercial – The Company offers a variety of loan options to meet the specific needs of our commercial customers including term loans, time notes and lines of credit. Such loans are made available to businesses for working capital needs such as inventory and receivables, business expansion and equipment purchases. Generally, a collateral lien is placed on equipment or other assets owned by the borrower. These loans carry a higher risk than commercial real estate loans due to the nature of the underlying collateral, which can be business assets such as equipment and accounts receivable. To reduce the risk, management also attempts to secure real estate as collateral and obtain personal guarantees of the borrowers.

Commercial Real Estate – The Company offers commercial real estate loans to finance real estate purchases, refinancings, expansions and improvements to commercial properties. Commercial real estate loans are made to finance the purchases of real estate, generally with completed structures. These commercial real estate loans are secured by first liens on the real estate, which may include apartments, commercial structures, housing businesses, healthcare facilities, and other non owner-occupied facilities. These loans are typically less risky than commercial loans, since they are secured by real estate and buildings, and are generally originated in amounts of no more than 80% of the appraised value of the property.

Agricultural – The Company offers a variety of agricultural loans to meet the needs of our agricultural customers including term loans, time notes, and lines of credit. These loans are made to purchase livestock, purchase and modernize equipment, and finance seasonal crop expenses. Generally, a collateral lien is placed on the livestock, equipment, produce inventories, and/or receivables owned by the borrower. These loans may carry a higher risk than commercial and agricultural real estate loans due to the industry price volatility, and in some cases, the perishable nature of the underlying collateral. To reduce these risks, management may attempt to secure these loans with additional real estate collateral, obtain personal guarantees of the borrowers, or obtain government loan guarantees to provide further support.

Agricultural Real Estate – The Company offers real estate loans to our agricultural customers to finance farm related real estate purchases, refinancings, expansions, and improvements to agricultural properties such as barns, production facilities, and land. The agricultural real estate loans are secured by first liens on the farm real estate. Because they are secured by land and buildings, these loans may be less risky than agricultural loans. These loans are typically originated in amounts of no more than 75% of the appraised value of the property. Government loan guarantees may be obtained to provide further support.

Business Banking - The Company offers a variety of loan options to meet the specific needs of our business banking customers including term loans, business banking mortgages and lines of credit. Such loans are generally less than $0.5 million and are made available to businesses for working capital such as inventory and receivables, business expansion, equipment purchases, and agricultural needs. Generally, a collateral lien is placed on equipment or other assets owned by the borrower such as inventory and/or receivables. These loans carry a higher risk than commercial loans due to the smaller size of the borrower and lower levels of capital. To reduce the risk, the Company obtains personal guarantees of the owners for a majority of the loans.

Consumer Loans

The Company offers a variety of consumer loan products including indirect, home equity, and direct loans.

Indirect – The Company maintains relationships with many dealers primarily in the communities that we serve. Through these relationships, the company primarily finances the purchases of automobiles and recreational vehicles (such as campers, boats, etc.) indirectly through dealer relationships. Approximately 75% of the indirect relationships represent automobile financing. Most of these loans carry a fixed rate of interest with principal repayment terms typically ranging from three to six years, based upon the nature of the collateral and the size of the loan. The majority of indirect consumer loans are underwritten on a secured basis using the underlying collateral being financed.

Home Equity – The Company offers fixed home equity loans as well as home equity lines of credit to consumers to finance home improvements, debt consolidation, education and other uses. Consumers are able to borrow up to 85% of the equity in their homes. The Company originates home equity lines of credit and second mortgage loans (loans secured by a second junior lien position on one-to-four-family residential real estate). These loans carry a higher risk than first mortgage residential loans as they are in a second position with respect to collateral. Risk is reduced through underwriting criteria, which include credit verification, appraisals, a review of the borrower's financial condition, and personal cash flows. A security interest, with title insurance when necessary, is taken in the underlying real estate.

Direct – The Company offers a variety of consumer installment loans to finance vehicle purchases, mobile home purchases and personal expenditures. Most of these loans carry a fixed rate of interest with principal repayment terms typically ranging from one to ten years, based upon the nature of the collateral and the size of the loan. The majority of consumer loans are underwritten on a secured basis using the underlying collateral being financed or a customer's deposit account. In addition to installment loans, the Company also offers personal lines of credit and overdraft protection. A minimal amount of loans are unsecured, which carry a higher risk of loss.

Residential Real Estate Mortgages

Residential real estate loans consist primarily of loans secured by first or second deeds of trust on primary residences. We originate adjustable-rate and fixed-rate, one-to-four-family residential real estate loans for the construction, purchase or refinancing of a mortgage. These loans are collateralized by owner-occupied properties located in the Company’s market area. Loans on one-to-four-family residential real estate are generally originated in amounts of no more than 85% of the purchase price or appraised value (whichever is lower), or have private mortgage insurance. The Company’s underwriting analysis for residential mortgage loans typically includes credit verification, independent appraisals, and a review of the borrower’s financial condition. Mortgage title insurance and hazard insurance are normally required. Construction loans have a unique risk, because they are secured by an incomplete dwelling. This risk is reduced through periodic site inspections, including one at each loan draw period.

For purposes of evaluating the adequacy of the allowance, the Company considers a number of significant factors that affect the collectability of the portfolio. For individually analyzed loans, these include estimates of loss exposure, which reflect the facts and circumstances that affect the likelihood of repayment of such loans as of the evaluation date. For homogeneous pools of loans, estimates of the Company’s exposure to credit loss reflect a current assessment of a number of factors, which could affect collectability. These factors include: past loss experience; size, trend, composition, and nature of loans; changes in lending policies and procedures, including underwriting standards and collection, charge-offs and recoveries; trends experienced in nonperforming and delinquent loans; current economic conditions in the Company’s market; portfolio concentrations that may affect loss experienced across one or more components of the portfolio; the effect of external factors such as competition, legal and regulatory requirements; and the experience, ability, and depth of lending management and staff. In addition, various regulatory agencies, as an integral component of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to make loan grade changes as well as recognize additions to the allowance based on their examinations.

After a thorough consideration of the factors discussed above, any required additions or reductions to the allowance for loan losses are made periodically by charges or credits to the provision for loan losses. These charges or credits are necessary to maintain the allowance at a level which management believes is reasonably reflective of overall inherent risk of probable loss in the portfolio. While management uses available information to recognize losses on loans, additions and reductions of the allowance may fluctuate from one reporting period to another. These fluctuations are reflective of changes in risk associated with portfolio content and/or changes in management’s assessment of any or all of the determining factors discussed above.

The following tables illustrate the changes in the allowance for loan losses by our portfolio segments for the three and six months ended June 30, 2014 and 2013:

							Residential
Three months ended June 30	Commercial			Consumer			Real Estate
	Loans			Loans			Mortgages			Unallocated			Total
Balance as of March 31, 2014	$	34,437		$	28,436		$	6,225		$	336		$	69,434
Charge-offs		(1,427	)		(3,648	)		(165	)		-			(5,240	)
Recoveries		314			714			146			-			1,174
Provision		1,799			2,471			(1	)		(103	)		4,166
Ending Balance as of June 30, 2014	$	35,123		$	27,973		$	6,205		$	233		$	69,534

Balance as of March 31, 2013	$	35,358		$	26,285		$	6,708		$	383		$	68,734
Charge-offs		(1,198	)		(3,653	)		(302	)		-			(5,153	)
Recoveries		416			696			89			-			1,201
Provision		3,128			3,128			311			(165	)		6,402
Ending Balance as of June 30, 2013	$	37,704		$	26,456		$	6,806		$	218		$	71,184

							Residential
Six months ended June 30,	Commercial			Consumer			Real Estate
	Loans			Loans			Mortgages			Unallocated			Total
Balance as of December 31, 2013	$	35,090		$	27,694		$	6,520		$	130		$	69,434
Charge-offs		(1,906	)		(7,680	)		(484	)		-			(10,070	)
Recoveries		713			1,455			240			-			2,408
Provision		1,226			6,504			(71	)		103			7,762
Ending Balance as of June 30, 2014	$	35,123		$	27,973		$	6,205		$	233		$	69,534

Balance as of December 31, 2012	$	35,624		$	27,162		$	6,252		$	296		$	69,334
Charge-offs		(4,520	)		(7,376	)		(973	)		-			(12,869	)
Recoveries		883			1,673			103			-			2,659
Provision		5,717			4,997			1,424			(78	)		12,060
Ending Balance as of June 30, 2013	$	37,704		$	26,456		$	6,806		$	218		$	71,184

For acquired loans, to the extent that we experience deterioration in borrower credit quality resulting in a decrease in our expected cash flows subsequent to acquisition of the loans, an allowance for loan losses would be established based on our estimate of future credit losses over the remaining life of the loans. As of June 30, 2014, included in the above tables, there was $1.5 million in the allowance for loan losses related to an acquired commercial loan. There was no allowance as of June 30, 2013 related to acquired loans. Net charge-offs related to acquired loans totaled approximately $0.1 million and $0.2 million during the three months ended June 30, 2014 and 2013, respectively, and are included in the table above. Net charge-offs related to acquired loans totaled approximately $0.2 million and $0.4 million during the six months ended June 30, 2014 and 2013, respectively, and are included in the table above.

The following tables illustrate the allowance for loan losses and the recorded investment by portfolio segments as of June 30, 2014 and December 31, 2013:

Allowance for Loan Losses and Recorded Investment in Loans

(in thousands)

					Residential
	Commercial		Consumer		Real Estate
	Loans		Loans		Mortgages		Unallocated		Total
As of June 30, 2014
Allowance for loan losses	$	35,123	$	27,973	$	6,205	$	233	$	69,534

Allowance for loans individually evaluated for impairment		2,100		-		-				2,100

Allowance for loans collectively evaluated for impairment	$	33,023	$	27,973	$	6,205	$	233	$	67,434

Ending balance of loans	$	2,476,246	$	2,025,035	$	1,073,207			$	5,574,488

Ending balance of originated loans individually evaluated for impairment		13,874		5,600		2,738				22,212
Ending balance of acquired loans individually evaluated for impairment		9,672		-		-				9,672
Ending balance of acquired loans collectively evaluated for impairment		367,818		179,253		289,405				836,476
Ending balance of originated loans collectively evaluated for impairment	$	2,084,882	$	1,840,182	$	781,064			$	4,706,128

As of December 31, 2013
Allowance for loan losses	$	35,090	$	27,694	$	6,520	$	130	$	69,434

Allowance for loans individually evaluated for impairment		715		-		-				715

Allowance for loans collectively evaluated for impairment	$	34,375	$	27,694	$	6,520	$	130	$	68,719

Ending balance of loans	$	2,392,621	$	1,972,537	$	1,041,637			$	5,406,795

Ending balance of originated loans individually evaluated for impairment		16,120		3,248		2,012				21,380
Ending balance of acquired loans individually evaluated for impairment		10,060		-		-				10,060
Ending balance of acquired loans collectively evaluated for impairment		392,329		219,587		308,416				920,332
Ending balance of originated loans collectively evaluated for impairment	$	1,974,112	$	1,749,702	$	731,209			$	4,455,023

Credit Quality of Loans

Loans are placed on nonaccrual status when timely collection of principal and interest in accordance with contractual terms is doubtful. Loans are transferred to nonaccrual status generally when principal or interest payments become ninety days delinquent, unless the loan is well secured and in the process of collection, or sooner when management concludes or circumstances indicate that borrowers may be unable to meet contractual principal or interest payments. When a loan is transferred to a nonaccrual status, all interest previously accrued in the current period but not collected is reversed against interest income in that period. Interest accrued in a prior period and not collected is charged-off against the allowance for loan losses. The Company’s nonaccrual policies are the same for all classes of financing receivable.

If ultimate repayment of a nonaccrual loan is expected, any payments received are applied in accordance with contractual terms. If ultimate repayment of principal is not expected, any payment received on a nonaccrual loan is applied to principal until ultimate repayment becomes expected. Nonaccrual loans are returned to accrual status when they become current as to principal and interest and demonstrate a period of performance under the contractual terms and, in the opinion of management, are fully collectible as to principal and interest. When in the opinion of management the collection of principal appears unlikely, the loan balance is charged-off in total or in part. For loans in all portfolios, the principal amount is charged off in full or in part as soon as management determines, based on available facts, that the collection of principal in full is improbable. For commercial loans, management considers specific facts and circumstances relative to individual credits in making such a determination. For consumer and residential loan classes, management uses specific guidance and thresholds from the Federal Financial Institutions Examination Council’s Uniform Retail Credit Classification and Account Management Policy.

The following table illustrates the Company’s nonaccrual loans by loan class:

Loans on Nonaccrual Status as of:

(In thousands)	June 30, 2014		December 31, 2013
ORIGINATED
Commercial Loans
Commercial	$	3,885	$	3,669
Commercial Real Estate		6,616		7,834
Agricultural		1,343		1,135
Agricultural Real Estate		1,590		961
Business Banking		6,008		5,701
		19,442		19,300

Consumer Loans
Indirect		1,359		1,461
Home Equity		7,772		5,931
Direct		67		86
		9,198		7,478

Residential Real Estate Mortgages		7,711		7,105

	$	36,351	$	33,883

ACQUIRED
Commercial Loans
Commercial	$	6,339	$	6,599
Commercial Real Estate		3,429		3,559
Business Banking		954		1,340
		10,722		11,498

Consumer Loans
Indirect		118		93
Home Equity		514		570
Direct		31		49
		663		712

Residential Real Estate Mortgages		3,498		3,872

	$	14,883	$	16,082

TOTAL NONACCRUAL LOANS	$	51,234	$	49,965

The following tables set forth information with regard to past due and nonperforming loans by loan class as of June 30, 2014 and December 31, 2013:

Age Analysis of Past Due Financing Receivables

As of June 30, 2014

(in thousands)

					Greater Than
	31-60 Days		61-90 Days		90 Days		Total						Recorded
	Past Due		Past Due		Past Due		Past Due						Total
	Accruing		Accruing		Accruing		Accruing		Non-Accrual		Current		Loans
ORIGINATED
Commercial Loans
Commercial	$	53	$	-	$	-	$	53	$	3,885	$	653,268	$	657,206
Commercial Real Estate		-		-		-		-		6,616		994,773		1,001,389
Agricultural		170		-		-		170		1,343		55,572		57,085
Agricultural Real Estate		4		-		-		4		1,590		40,768		42,362
Business Banking		869		451		-		1,320		6,008		333,386		340,714
		1,096		451		-		1,547		19,442		2,077,767		2,098,756

Consumer Loans
Indirect		12,444		2,015		1,100		15,559		1,359		1,265,140		1,282,058
Home Equity		4,470		995		839		6,304		7,772		494,123		508,199
Direct		529		138		27		694		67		54,764		55,525
		17,443		3,148		1,966		22,557		9,198		1,814,027		1,845,782
Residential Real Estate Mortgages		3,082		594		119		3,795		7,711		772,296		783,802
	$	21,621	$	4,193	$	2,085	$	27,899	$	36,351	$	4,664,090	$	4,728,340

ACQUIRED
Commercial Loans
Commercial	$	14	$	-	$	-	$	14	$	6,339		92,335	$	98,688
Commercial Real Estate		582		-		-		582		3,429		210,204		214,215
Business Banking		441		-		-		441		954		63,192		64,587
		1,037		-		-		1,037		10,722		365,731		377,490
Consumer Loans
Indirect		481		114		54		649		118		91,212		91,979
Home Equity		370		204		36		610		514		80,068		81,192
Direct		73		6		11		90		31		5,961		6,082
		924		324		101		1,349		663		177,241		179,253
Residential Real Estate Mortgages		1,317		-		-		1,317		3,498		284,590		289,405
	$	3,278	$	324	$	101	$	3,703	$	14,883	$	827,562	$	846,148
Total Loans	$	24,899	$	4,517	$	2,186	$	31,602	$	51,234	$	5,491,652	$	5,574,488

Age Analysis of Past Due Financing Receivables

As of December 31, 2013

(in thousands)

					Greater Than
	31-60 Days		61-90 Days		90 Days		Total						Recorded
	Past Due		Past Due		Past Due		Past Due						Total
	Accruing		Accruing		Accruing		Accruing		Non-Accrual		Current		Loans
ORIGINATED
Commercial Loans
Commercial	$	105	$	247	$	-	$	352	$	3,669	$	612,402	$	616,423
Commercial Real Estate		1,366		-		-		1,366		7,834		925,116		934,316
Agricultural		150		21		-		171		1,135		63,856		65,162
Agricultural Real Estate		519		-		-		519		961		35,172		36,652
Business Banking		1,228		122		105		1,455		5,701		330,523		337,679
		3,368		390		105		3,863		19,300		1,967,069		1,990,232

Consumer Loans
Indirect		14,093		2,878		1,583		18,554		1,461		1,141,829		1,161,844
Home Equity		6,033		1,888		1,115		9,036		5,931		517,856		532,823
Direct		679		125		46		850		86		57,347		58,283
		20,805		4,891		2,744		28,440		7,478		1,717,032		1,752,950
Residential Real Estate Mortgages		3,951		379		808		5,138		7,105		720,978		733,221
	$	28,124	$	5,660	$	3,657	$	37,441	$	33,883	$	4,405,079	$	4,476,403

ACQUIRED
Commercial Loans
Commercial	$	24	$	-	$	-	$	24	$	6,599	$	96,603	$	103,226
Commercial Real Estate		-		-		-		-		3,559		225,455		229,014
Business Banking		320		2		-		322		1,340		68,487		70,149
		344		2		-		346		11,498		390,545		402,389

Consumer Loans
Indirect		939		113		71		1,123		93		123,870		125,086
Home Equity		753		63		-		816		570		85,690		87,076
Direct		76		56		9		141		49		7,235		7,425
		1,768		232		80		2,080		712		216,795		219,587
Residential Real Estate Mortgages		1,725		-		-		1,725		3,872		302,819		308,416
	$	3,837	$	234	$	80	$	4,151	$	16,082	$	910,159	$	930,392
Total Loans	$	31,961	$	5,894	$	3,737	$	41,592	$	49,965	$	5,315,238	$	5,406,795

There were no material commitments to extend further credit to borrowers with nonperforming loans.

Impaired Loans

The methodology used to establish the allowance for loan losses on impaired loans incorporates specific allocations on loans analyzed individually. Classified and nonperforming loans with outstanding balances of $0.5 million or more and all troubled debt restructured loans (“TDR”) are evaluated for impairment through the Company’s quarterly status review process. In determining that we will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreements, we consider factors such as payment history and changes in the financial condition of individual borrowers, local economic conditions, historical loss experience and the conditions of the various markets in which the collateral may be liquidated. For loans that are impaired as defined by accounting standards, impairment is measured by one of three methods: 1) the fair value of collateral less cost to sell, 2) present value of expected future cash flows or 3) the loan’s observable market price. All impaired loans are reviewed on a quarterly basis for changes in the measurement of impairment. Any change to the previously recognized impairment loss is recognized as a change to the allowance account and recorded in the consolidated statement of income as a component of the provision for loan losses.

The following table provides information on loans specifically evaluated for impairment as of June 30, 2014 and December 31, 2013:

	June 30, 2014						December 31, 2013
	Recorded		Unpaid				Recorded		Unpaid
	Investment		Principal				Investment		Principal
	Balance		Balance		Related		Balance		Balance		Related
(in thousands)	(Book)		(Legal)		Allowance		(Book)		(Legal)		Allowance
ORIGINATED
With no related allowance recorded:
Commercial Loans
Commercial	$	2,000	$	2,096			$	4,721	$	4,777
Commercial Real Estate		6,854		7,823				4,613		5,164
Agricultural		119		189				125		195
Agricultural Real Estate		1,406		1,697				1,431		1,708
Business Banking		702		1,094				210		602
Total Commercial Loans		11,081		12,899				11,100		12,446

Consumer Loans
Home Equity		5,600		6,031				3,248		3,472

Residential Real Estate Mortgages		2,738		3,073				2,012		2,255
Total		19,419		22,003				16,360		18,173

With an allowance recorded:
Commercial Loans
Commercial Real Estate		2,793		4,649		600		5,020		6,877		715

ACQUIRED
With no related allowance recorded:
Commercial Loans
Commercial		-		-				6,501		6,538
Commercial Real Estate		3,430		3,836				3,559		3,842
Total Commercial Loans		3,430		3,836				10,060		10,380

With an allowance recorded:
Commercial Loans
Commercial		6,242		6,496		1,500		-		-		-

Total:	$	31,884	$	36,984	$	2,100	$	31,440	$	35,430	$	715

The following tables summarize the average recorded investments on impaired loans specifically evaluated for impairment and the interest income recognized for the three months ended June 30, 2014 and 2013:

	For the three months ended
	June 30, 2014				June 30, 2013
	Average				Average
	Recorded		Interest Income		Recorded		Interest Income
(in thousands)	Investment		Recognized		Investment		Recognized
ORIGINATED
Commercial Loans
Commercial	$	2,013	$	-	$	3,354	$	29
Commercial Real Estate		10,062		42		11,222		(51	)
Agricultural		123		-		201		(3	)
Agricultural Real Estate		1,412		12		896		12
Business Banking		548		11		78		3
Consumer Loans
Home Equity		5,289		60		2,967		29
Residential Real Estate Mortgage		2,803		26		1,998		17
Total Originated	$	22,250	$	151	$	20,716	$	36

ACQUIRED
Commercial Loans
Commercial		6,315		-		-		-
Commercial Real Estate		3,462		-		-		-
Total Acquired	$	9,777	$	-	$	-	$	-

Total Loans	$	32,027	$	151	$	20,716	$	36

	For the six months ended
	June 30, 2014				June 30, 2013
	Average				Average
	Recorded		Interest Income		Recorded		Interest Income
(in thousands)	Investment		Recognized		Investment		Recognized
ORIGINATED
Commercial Loans
Commercial	$	2,025	$	-	$	4,331	$	58
Commercial Real Estate		10,739		84		11,361		21
Agricultural		124		1		270		1
Agricultural Real Estate		1,418		23		898		24
Business Banking		429		23		79		3
Consumer Loans
Home Equity		4,959		103		2,944		58
Residential Real Estate Mortgage		2,778		50		2,028		28
Total Originated		22,472		284		21,911		193

ACQUIRED
Commercial Loans
Commercial		6,375		-		-		-
Commercial Real Estate		3,493		-		-		-
Total Acquired	$	9,868	$	-	$	-	$	-

Total Loans	$	32,339	$	284	$	21,911	$	193

Credit Quality Indicators

The Company has developed an internal loan grading system to evaluate and quantify the Company’s loan portfolio with respect to quality and risk. The system focuses on, among other things, financial strength of borrowers, experience and depth of borrower’s management, primary and secondary sources of repayment, payment history, nature of the business, and outlook on particular industries. The internal grading system enables the Company to monitor the quality of the entire loan portfolio on a consistent basis and provide management with an early warning system, enabling recognition and response to problem loans and potential problem loans.

Commercial Grading System

For commercial and agricultural loans, the Company uses a grading system that relies on quantifiable and measurable characteristics when available. This would include comparison of financial strength to available industry averages, comparison of transaction factors (loan terms and conditions) to loan policy, and comparison of credit history to stated repayment terms and industry averages. Some grading factors are necessarily more subjective such as economic and industry factors, regulatory environment, and management. Classified commercial loans consist of loans graded substandard and below. The grading system for commercial and agricultural loans is as follows:

Doubtful

A doubtful loan has a high probability of total or substantial loss, but because of specific pending events that may strengthen the asset, its classification as a loss is deferred. Doubtful borrowers are usually in default, lack adequate liquidity or capital, and lack the resources necessary to remain an operating entity. Pending events can include mergers, acquisitions, liquidations, capital injections, the perfection of liens on additional collateral, the valuation of collateral, and refinancing. Generally, pending events should be resolved within a relatively short period and the ratings will be adjusted based on the new information. Nonaccrual treatment is required for doubtful assets because of the high probability of loss.

Substandard

Substandard loans have a high probability of payment default, or they have other well-defined weaknesses. They require more intensive supervision by bank management. Substandard loans are generally characterized by current or expected unprofitable operations, inadequate debt service coverage, inadequate liquidity, or marginal capitalization. Repayment may depend on collateral or other credit risk mitigants. For some Substandard loans, the likelihood of full collection of interest and principal may be in doubt and those loans should be placed on nonaccrual. Although Substandard assets in the aggregate will have a distinct potential for loss, an individual asset’s loss potential does not have to be distinct for the asset to be rated Substandard.

Special Mention

Special Mention loans have potential weaknesses that may, if not checked or corrected, weaken the asset or inadequately protect the Company’s position at some future date. These loans pose elevated risk, but their weakness does not yet justify a Substandard classification. Borrowers may be experiencing adverse operating trends (declining revenues or margins) or may be struggling with an ill-proportioned balance sheet (e.g., increasing inventory without an increase in sales, high leverage, tight liquidity). Adverse economic or market conditions, such as interest rate increases or the entry of a new competitor, may also support a Special Mention rating. Although a Special Mention loan has a higher probability of default than a pass asset, its default is not imminent.

Pass

Loans graded as Pass encompass all loans not graded as Doubtful, Substandard, or Special Mention. Pass loans are in compliance with loan covenants, and payments are generally made as agreed. Pass loans range from superior quality to fair quality.

Business Banking Grading System

Business banking loans are graded as either Classified or Non-classified:

Classified

Classified loans are inadequately protected by the current worth and paying capacity of the obligor or, if applicable, the collateral pledged. These loans have a well-defined weakness, or weaknesses, that jeopardize the liquidation of the debt, or in some cases make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Classified loans have a high probability of payment default, or a high probability of total or substantial loss. These loans require more intensive supervision by management and are generally characterized by current or expected unprofitable operations, inadequate debt service coverage, inadequate liquidity, or marginal capitalization. Repayment may depend on collateral or other credit risk mitigants. When the likelihood of full collection of interest and principal may be in doubt; classified loans are considered to have a nonaccrual status. In some cases, Classified loans are considered uncollectible and of such little value that their continuance as assets is not warranted.

Non-classified

Loans graded as Non-classified encompass all loans not graded as Classified. Non-classified loans are in compliance with loan covenants, and payments are generally made as agreed.

Consumer and Residential Mortgage Grading System

Consumer and Residential Mortgage loans are graded as either Performing or Nonperforming. Nonperforming loans are loans that are 1) over 90 days past due and interest is still accruing, 2) on nonaccrual status or 3) restructured. All loans not meeting any of these three criteria are considered Performing.

The following tables illustrate the Company’s credit quality by loan class as of June 30, 2014 and December 31, 2013:

Credit Quality Indicators

As of June 30, 2014

ORIGINATED
Commercial Credit Exposure			Commercial				Agricultural
By Internally Assigned Grade:	Commercial		Real Estate		Agricultural		Real Estate		Total
Pass	$	606,388	$	946,883	$	52,603	$	38,503	$	1,644,377
Special Mention		11,782		19,949		354		7		32,092
Substandard		39,036		34,557		4,052		3,852		81,497
Doubtful		-		-		76		-		76
Total	$	657,206	$	1,001,389	$	57,085	$	42,362	$	1,758,042

Business Banking Credit Exposure
By Internally Assigned Grade:	Business Banking								Total
Non-classified	$	323,200							$	323,200
Classified		17,514								17,514
Total	$	340,714							$	340,714

Consumer Credit Exposure
By Payment Activity:	Indirect		Home Equity		Direct				Total
Performing	$	1,279,599	$	499,588	$	55,431			$	1,834,618
Nonperforming		2,459		8,611		94				11,164
Total	$	1,282,058	$	508,199	$	55,525			$	1,845,782

Residential Mortgage Credit Exposure	Residential
By Payment Activity:	Mortgage								Total
Performing	$	775,972							$	775,972
Nonperforming		7,830								7,830
Total	$	783,802							$	783,802

Credit Quality Indicators

As of June 30, 2014

ACQUIRED
Commercial Credit Exposure			Commercial
By Internally Assigned Grade:	Commercial		Real Estate		Agricultural		Total
Pass	$	84,842	$	197,499	$	-	$	282,341
Special Mention		4,339		2,478		-		6,817
Substandard		9,507		14,238		-		23,745
Total	$	98,688	$	214,215	$	-	$	312,903

Business Banking Credit Exposure
By Internally Assigned Grade:	Business Banking						Total
Non-classified	$	59,227					$	59,227
Classified		5,360						5,360
Total	$	64,587					$	64,587

Consumer Credit Exposure
By Payment Activity:	Indirect		Home Equity		Direct		Total
Performing	$	91,807	$	80,642	$	6,040	$	178,489
Nonperforming		172		550		42		764
Total	$	91,979	$	81,192	$	6,082	$	179,253

Residential Mortgage Credit Exposure	Residential
By Payment Activity:	Mortgage						Total
Performing	$	285,907					$	285,907
Nonperforming		3,498						3,498
Total	$	289,405					$	289,405

Credit Quality Indicators

As of December 31, 2013

ORIGINATED
Commercial Credit Exposure			Commercial				Agricultural
By Internally Assigned Grade:	Commercial		Real Estate		Agricultural		Real Estate		Total
Pass	$	576,079	$	878,411	$	60,043	$	33,136	$	1,547,669
Special Mention		16,836		22,777		381		43		40,037
Substandard		23,508		33,128		4,726		3,473		64,835
Doubtful		-		-		12		-		12
Total	$	616,423	$	934,316	$	65,162	$	36,652	$	1,652,553

Business Banking Credit Exposure
By Internally Assigned Grade:	Business Banking								Total
Non-classified	$	319,578							$	319,578
Classified		18,101								18,101
Total	$	337,679							$	337,679

Consumer Credit Exposure
By Payment Activity:	Indirect		Home Equity		Direct				Total
Performing	$	1,158,800	$	525,777	$	58,151			$	1,742,728
Nonperforming		3,044		7,046		132				10,222
Total	$	1,161,844	$	532,823	$	58,283			$	1,752,950

Residential Mortgage Credit Exposure	Residential
By Payment Activity:	Mortgage								Total
Performing	$	725,308							$	725,308
Nonperforming		7,913								7,913
Total	$	733,221							$	733,221

Credit Quality Indicators

As of December 31, 2013

ACQUIRED
Commercial Credit Exposure			Commercial
By Internally Assigned Grade:	Commercial		Real Estate		Agricultural		Total
Pass	$	85,692	$	205,010	$	-	$	290,702
Special Mention		2,230		6,183		-		8,413
Substandard		15,304		17,821		-		33,125
Total	$	103,226	$	229,014	$	-	$	332,240

Business Banking Credit Exposure
By Internally Assigned Grade:	Business Banking						Total
Non-classified	$	65,437					$	65,437
Classified		4,712						4,712
Total	$	70,149					$	70,149

Consumer Credit Exposure
By Payment Activity:	Indirect		Home Equity		Direct		Total
Performing	$	124,922	$	86,506	$	7,367	$	218,795
Nonperforming		164		570		58		792
Total	$	125,086	$	87,076	$	7,425	$	219,587

Residential Mortgage Credit Exposure	Residential
By Payment Activity:	Mortgage						Total
Performing	$	304,544					$	304,544
Nonperforming		3,872						3,872
Total	$	308,416					$	308,416

Troubled Debt Restructured Loans

The Company’s loan portfolio includes certain loans that have been modified where economic concessions have been granted to borrowers who have experienced or are expected to experience financial difficulties. These concessions typically result from the Company’s loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. Certain TDRs are classified as nonperforming at the time of restructure and may only be returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period, generally six months. Substantially all of these modifications included one or a combination of the following: an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; temporary reduction in the interest rate; or change in scheduled payment amount.

When the Company modifies a loan, management evaluates any possible impairment based on the present value of the expected future cash flows, discounted at the contractual interest rate of the original loan agreement, except when the sole (remaining) source of repayment for the loan is the operation or liquidation of the collateral. In these cases, management uses the current fair value of the collateral, less selling costs, instead of discounted cash flows. If management determines that the value of the modified loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized by segment or class of loan as applicable, through an allowance estimate or a charge-off to the allowance. Segment and class status is determined by the loan’s classification at origination.

TDRs that occurred during the three month period ending June 30, 2014 consisted of 3 home equity loans totaling $0.4 million, 5 direct consumer loans totaling $0.3 million, and 2 residential real estate mortgages totaling $0.2 million. For all such modifications, the pre and post outstanding recorded investment amount remained unchanged. During the three month period ending June 30, 2014 there were 2 defaults on home equity loan TDRs totaling $0.3 million and one default on a direct consumer loan TDR totaling $34,000.

TDRs that occurred during the six month period ending June 30, 2014 consisted of 5 home equity loans totaling $0.4 million, 25 direct consumer loans totaling $1.3 million, and 15 residential real estate mortgages totaling $1.2 million. For all such modifications, the pre and post outstanding recorded investment amount remained unchanged. During the six month period ending June 30, 2014 there were 2 defaults on home equity loan TDRs totaling $0.3 million, five defaults on direct consumer loan TDRs totaling $0.2 million, and one default on a residential real estate mortgage TDR totaling $0.1 million.

TDRs that occurred during the three month period ending June 30, 2013 consisted of one commercial reasl estate loan totaling $0.9 million, 10 home equity loans totaling $0.5 million, and one residential real estate mortgage totaling $0.1 million. For all such modifications, the pre and post outstanding recorded investment amount remained unchanged. During the three month period ending June 30, 2013 there were three defaults on home equity loan TDRs totaling $0.2 million.

TDRs that occurred during the six month period ending June 30, 2013 consisted of one commercial real estate loan totaling $0.9 million, 14 home equity loans totaling $0.6 million, and one residential real estate mortgage totaling $0.1 million. For all such modifications, the pre and post outstanding recorded investment amount remained unchanged. During the six month period ending June 30, 2013 there were three defaults on home equity loan TDRs totaling $0.2 million.