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 probable incurred 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 these risks, 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, loss emergence period, 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, 2016 and 2015:

Three months ended June 30,	Commercial Loans			Consumer Loans			Residential Real Estate Mortgages			Unallocated			Total
Balance as of March 31, 2016	$	25,299		$	31,035		$	7,984		$	-		$	64,318
Charge-offs		(649	)		(4,950	)		(268	)		-			(5,867	)
Recoveries		339			907			91			-			1,337
Provision		233			4,479			68			-			4,780
Ending Balance as of June 30, 2016	$	25,222		$	31,471		$	7,875		$	-		$	64,568

Balance as of March 31, 2015	$	31,278		$	26,156		$	7,698		$	227		$	65,359
Charge-offs		(584	)		(4,275	)		(509	)		-			(5,368	)
Recoveries		280			697			93			-			1,070
Provision		(2,648	)		5,736			999			(189	)		3,898
Ending Balance as of June 30, 2015	$	28,326		$	28,314		$	8,281		$	38		$	64,959

Six months ended June 30,	Commercial Loans			Consumer Loans			Residential Real Estate Mortgages			Unallocated			Total
Balance as of December 31, 2015	$	25,545		$	29,253		$	7,960		$	260		$	63,018
Charge-offs		(1,086	)		(10,363	)		(977	)		-			(12,426	)
Recoveries		1,104			1,881			113			-			3,098
Provision		(341	)		10,700			779			(260	)		10,878
Ending Balance as of June 30, 2016	$	25,222		$	31,471		$	7,875		$	-		$	64,568

Balance as of December 31, 2014	$	32,433		$	26,720		$	7,130		$	76		$	66,359
Charge-offs		(1,382	)		(8,653	)		(1,013	)		-			(11,048	)
Recoveries		514			1,445			149			-			2,108
Provision		(3,239	)		8,802			2,015			(38	)		7,540
Ending Balance as of June 30, 2015	$	28,326		$	28,314		$	8,281		$	38		$	64,959

Included in the above table there was $0.8 million and $1.9 million in the allowance for loan losses related to acquired commercial loans as of June 30, 2016 and June 30, 2015, respectively. Net charge-offs related to acquired loans totaled approximately $0.1 million and $0.1 million during the three months ended June 30, 2016 and 2015, respectively, and approximately $0.4 million and $0.7 million during the six months ended June 30, 2016 and 2015, 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, 2016 and December 31, 2015:

Allowance for Loan Losses and Recorded Investment in Loans

(in thousands)

	Commercial Loans		Consumer Loans		Residential Real Estate Mortgages		Unallocated		Total
As of June 30, 2016
Allowance for loan losses	$	25,222	$	31,471	$	7,875	$	-	$	64,568

Allowance for loans individually evaluated for impairment		3,215		-		-		-		3,215

Allowance for loans collectively evaluated for impairment	$	22,007	$	31,471	$	7,875	$	-	$	61,353

Ending balance of loans	$	2,673,691	$	2,146,314	$	1,219,388			$	6,039,393

Ending balance of originated loans individually evaluated for impairment		20,034		8,190		6,174				34,398
Ending balance of acquired loans individually evaluated for impairment		1,205		-		-				1,205
Ending balance of acquired loans collectively evaluated for impairment		268,814		77,387		214,668				560,869
Ending balance of originated loans collectively evaluated for impairment	$	2,383,638	$	2,060,737	$	998,546			$	5,442,921

As of December 31, 2015
Allowance for loan losses	$	25,545	$	29,253	$	7,960	$	260	$	63,018

Allowance for loans individually evaluated for impairment		2,005		-		-		-		2,005

Allowance for loans collectively evaluated for impairment	$	23,540	$	29,253	$	7,960	$	260	$	61,013

Ending balance of loans	$	2,589,707	$	2,096,646	$	1,196,780			$	5,883,133

Ending balance of originated loans individually evaluated for impairment		12,253		7,693		6,017				25,963
Ending balance of acquired loans individually evaluated for impairment		1,205		-		-				1,205
Ending balance of acquired loans collectively evaluated for impairment		284,524		95,427		230,358				610,309
Ending balance of originated loans collectively evaluated for impairment	$	2,291,725	$	1,993,526	$	960,405			$	5,245,656

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 90 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 tables set forth information with regard to past due and nonperforming loans by loan class as of June 30, 2016 and December 31, 2015:

Age Analysis of Past Due Financing Receivables

As of June 30, 2016

(in thousands)

	31-60 Days Past Due Accruing		61-90 Days Past Due Accruing		Greater Than 90 Days Past Due Accruing		Total Past Due Accruing		Nonaccrual		Current		Recorded Total Loans
ORIGINATED
Commercial Loans
Commercial	$	663	$	85	$	-	$	748	$	3,362	$	656,219	$	660,329
Commercial Real Estate		1,576		-		-		1,576		13,078		1,254,984		1,269,638
Agricultural		86		-		-		86		669		35,007		35,762
Agricultural Real Estate		-		-		-		-		470		29,909		30,379
Business Banking		2,234		461		-		2,695		3,723		401,146		407,564
		4,559		546		-		5,105		21,302		2,377,265		2,403,672

Consumer Loans
Indirect		14,096		3,542		1,398		19,036		1,499		1,528,126		1,548,661
Home Equity		3,499		740		154		4,393		3,241		451,357		458,991
Direct		450		88		20		558		46		60,671		61,275
		18,045		4,370		1,572		23,987		4,786		2,040,154		2,068,927
Residential Real Estate Mortgages		2,695		1,516		27		4,238		6,451		994,031		1,004,720
	$	25,299	$	6,432	$	1,599	$	33,330	$	32,539	$	5,411,450	$	5,477,319

ACQUIRED
Commercial Loans
Commercial	$	-	$	72	$	-	$	72	$	-	$	62,882	$	62,954
Commercial Real Estate		443		-		-		443		1,313		160,176		161,932
Business Banking		420		389		-		809		406		43,918		45,133
		863		461		-		1,324		1,719		266,976		270,019

Consumer Loans
Indirect		105		8		13		126		68		16,407		16,601
Home Equity		368		-		-		368		440		56,679		57,487
Direct		25		21		1		47		23		3,229		3,299
		498		29		14		541		531		76,315		77,387
Residential Real Estate Mortgages		673		642		-		1,315		2,608		210,745		214,668
	$	2,034	$	1,132	$	14	$	3,180	$	4,858	$	554,036	$	562,074
Total Loans	$	27,333	$	7,564	$	1,613	$	36,510	$	37,397	$	5,965,486	$	6,039,393

Age Analysis of Past Due Financing Receivables

As of December 31, 2015

(in thousands)

	31-60 Days Past Due Accruing		61-90 Days Past Due Accruing		Greater Than 90 Days Past Due Accruing		Total Past Due Accruing		Nonaccrual		Current		Recorded Total Loans
ORIGINATED
Commercial Loans
Commercial	$	782	$	23	$	-	$	805	$	2,817	$	640,696	$	644,318
Commercial Real Estate		39		32		-		71		5,546		1,189,280		1,194,897
Agricultural		94		-		-		94		897		33,633		34,624
Agricultural Real Estate		-		-		-		-		1,046		28,172		29,218
Business Banking		912		394		-		1,306		4,247		395,368		400,921
		1,827		449		-		2,276		14,553		2,287,149		2,303,978

Consumer Loans
Indirect		15,731		2,963		2,271		20,965		1,786		1,454,499		1,477,250
Home Equity		3,396		1,671		340		5,407		4,835		454,473		464,715
Direct		425		201		28		654		49		58,551		59,254
		19,552		4,835		2,639		27,026		6,670		1,967,523		2,001,219
Residential Real Estate Mortgages		3,301		365		696		4,362		7,713		954,347		966,422
	$	24,680	$	5,649	$	3,335	$	33,664	$	28,936	$	5,209,019	$	5,271,619


ACQUIRED
Commercial Loans
Commercial	$	-	$	-	$	-	$	-	$	-	$	68,991	$	68,991
Commercial Real Estate		-		-		-		-		1,313		165,630		166,943
Business Banking		288		-		-		288		307		49,200		49,795
		288		-		-		288		1,620		283,821		285,729

Consumer Loans
Indirect		143		11		1		155		104		27,516		27,775
Home Equity		327		132		-		459		457		62,811		63,727
Direct		76		20		-		96		43		3,786		3,925
		546		163		1		710		604		94,113		95,427
Residential Real Estate Mortgages		1,443		293		326		2,062		2,584		225,712		230,358
	$	2,277	$	456	$	327	$	3,060	$	4,808	$	603,646	$	611,514
Total Loans	$	26,957	$	6,105	$	3,662	$	36,724	$	33,744	$	5,812,665	$	5,883,133

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 (“TDRs”) 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 discounted at the loan's original effective interest rate or 3) the loan’s observable market price. All impaired loans are reviewed on a quarterly basis for changes in the level of impairment. Any change to the previously recognized impairment loss is recognized as a change to the allowance account and recorded in the unaudited interim consolidated statements 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, 2016 and December 31, 2015:

	June 30, 2016							December 31, 2015
(in thousands)	Recorded Investment Balance(Book)		UnpaidPrincipalBalance(Legal)		RelatedAllowance			RecordedInvestmentBalance(Book)		UnpaidPrincipalBalance(Legal)		RelatedAllowance
ORIGINATED
With no related allowance recorded:
Commercial Loans
Commercial	$	2,194	$	2,444				$	2,244	$	2,490
Commercial Real Estate		7,836		7,905					3,165		3,175
Agricultural		18		24					576		1,164
Agricultural Real Estate		608		733					618		744
Business Banking		965		1,027					983		1,033
Total Commercial Loans		11,621		12,133					7,586		8,606

Consumer Loans
Indirect		8		19					12		21
Home Equity		8,182		9,121					7,681		8,574
Direct		-		1					-		-
Total Consumer Loans		8,190		9,141					7,693		8,595

Residential Real Estate Mortgages		6,174		6,893					6,017		6,627
Total		25,985		28,167					21,296		23,828

With an allowance recorded:
Commercial Loans
Commercial		1,022		1,022		$	495		457		457		$	300
Commercial Real Estate		7,391		9,239			1,890		4,210		6,059			970
Total Commercial Loans		8,413		10,261			2,385		4,667		6,516			1,270

ACQUIRED
With an allowance recorded:
Commercial Loans
Commercial Real Estate		1,205		1,321			830		1,205		1,321			735
Total Commercial Loans		1,205		1,321			830		1,205		1,321			735

Total:	$	35,603	$	39,749		$	3,215	$	27,168	$	31,665		$	2,005

The following tables summarize the average recorded investments on impaired loans specifically evaluated for impairment and the interest income recognized for the three and six months ended June 30, 2016 and 2015:

	For the three months ended
	June 30, 2016				June 30, 2015
(in thousands)	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
ORIGINATED
Commercial Loans
Commercial	$	3,126	$	-	$	1,768	$	61
Commercial Real Estate		15,278		-		9,060		41
Agricultural		18		-		19		-
Agricultural Real Estate		610		11		630		12
Business Banking		969		6		975		2
Consumer Loans
Indirect		9		-		16		-
Home Equity		8,223		120		6,692		92
Direct		-		-		1		-
Residential Real Estate Mortgage		6,203		67		4,636		33
Total Originated	$	34,436	$	204	$	23,797	$	241

ACQUIRED
Commercial Loans
Commercial		-		-		2,602		-
Commercial Real Estate		1,205		-		7,205		-
Total Acquired	$	1,205	$	-	$	9,807	$	-
Total Loans	$	35,641	$	204	$	33,604	$	241

	For the six months ended
	June 30, 2016				June 30, 2015
(in thousands)	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
ORIGINATED
Commercial Loans
Commercial	$	2,972	$	-	$	1,742	$	86
Commercial Real Estate		14,264		74		9,091		82
Agricultural		98		1		19		1
Agricultural Real Estate		613		22		633		23
Business Banking		973		12		932		6
Consumer Loans
Indirect		10		-		11		-
Home Equity		8,093		241		6,560		164
Direct		-		-		1		-
Residential Real Estate Mortgage		6,154		134		4,476		63
Total Originated	$	33,177	$	484	$	23,465	$	425

ACQUIRED
Commercial Loans
Commercial		-		-		2,722		-
Commercial Real Estate		1,205		-		7,176		-
Total Acquired	$	1,205	$	-	$	9,898	$	-
Total Loans	$	34,382	$	484	$	33,363	$	425

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.

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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.

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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:

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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.

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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 and it is expected that such timely payments of principal and interest will continue.

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, 2016 and December 31, 2015:

Credit Quality Indicators

As of June 30, 2016

ORIGINATED
Commercial Credit Exposure By Internally Assigned Grade:	Commercial		Commercial Real Estate		Agricultural		Agricultural Real Estate		Total
Pass	$	610,816	$	1,219,723	$	35,365	$	29,448	$	1,895,352
Special Mention		17,774		13,035		1		5		30,815
Substandard		31,739		36,880		388		926		69,933
Doubtful		-		-		8		-		8
Total	$	660,329	$	1,269,638	$	35,762	$	30,379	$	1,996,108

Business Banking Credit Exposure By Internally Assigned Grade:	Business Banking								Total
Non-classified	$	393,805							$	393,805
Classified		13,759								13,759
Total	$	407,564							$	407,564

Consumer Credit Exposure By Payment Activity:	Indirect		Home Equity		Direct				Total
Performing	$	1,545,764	$	455,596	$	61,209			$	2,062,569
Nonperforming		2,897		3,395		66				6,358
Total	$	1,548,661	$	458,991	$	61,275			$	2,068,927

Residential Mortgage Credit Exposure By Payment Activity:	Residential Mortgage								Total
Performing	$	998,242							$	998,242
Nonperforming		6,478								6,478
Total	$	1,004,720							$	1,004,720

Credit Quality Indicators

As of June 30, 2016

ACQUIRED
Commercial Credit Exposure By Internally Assigned Grade:	Commercial		Commercial Real Estate				Total
Pass	$	59,681	$	150,076			$	209,757
Special Mention		1,447		1,799				3,246
Substandard		1,826		10,057				11,883
Total	$	62,954	$	161,932			$	224,886

Business Banking Credit Exposure By Internally Assigned Grade:	Business Banking						Total
Non-classified	$	41,739					$	41,739
Classified		3,394						3,394
Total	$	45,133					$	45,133

Consumer Credit Exposure By Payment Activity:	Indirect		Home Equity		Direct		Total
Performing	$	16,520	$	57,047	$	3,275	$	76,842
Nonperforming		81		440		24		545
Total	$	16,601	$	57,487	$	3,299	$	77,387

Residential Mortgage Credit Exposure By Payment Activity:	Residential Mortgage						Total
Performing	$	212,060					$	212,060
Nonperforming		2,608						2,608
Total	$	214,668					$	214,668

Credit Quality Indicators

As of December 31, 2015

ORIGINATED
Commercial Credit Exposure By Internally Assigned Grade:	Commercial		Commercial Real Estate		Agricultural		Agricultural Real Estate		Total
Pass	$	604,405	$	1,144,832	$	33,565	$	27,320	$	1,810,122
Special Mention		9,726		21,587		311		429		32,053
Substandard		30,187		28,478		740		1,469		60,874
Doubtful		-		-		8		-		8
Total	$	644,318	$	1,194,897	$	34,624	$	29,218	$	1,903,057

Business Banking Credit Exposure By Internally Assigned Grade:	Business Banking								Total
Non-classified	$	386,397							$	386,397
Classified		14,524								14,524
Total	$	400,921							$	400,921
Total
Consumer Credit Exposure By Payment Activity:	Indirect		Home Equity		Direct				Total
Performing	$	1,473,193	$	459,540	$	59,177			$	1,991,910
Nonperforming		4,057		5,175		77				9,309
Total	$	1,477,250	$	464,715	$	59,254			$	2,001,219

Residential Mortgage Credit Exposure By Payment Activity:	Residential Mortgage								Total
Performing	$	958,013							$	958,013
Nonperforming		8,409								8,409
Total	$	966,422							$	966,422

Credit Quality Indicators

As of December 31, 2015

ACQUIRED
Commercial Credit Exposure By Internally Assigned Grade:	Commercial		Commercial Real Estate				Total
Pass	$	67,241	$	154,871			$	222,112
Special Mention		802		2,174				2,976
Substandard		948		9,898				10,846
Total	$	68,991	$	166,943			$	235,934

Business Banking Credit Exposure By Internally Assigned Grade:	Business Banking						Total
Non-classified	$	46,032					$	46,032
Classified		3,763						3,763
Total	$	49,795					$	49,795

Consumer Credit Exposure By Payment Activity:	Indirect		Home Equity		Direct		Total
Performing	$	27,670	$	63,270	$	3,882	$	94,822
Nonperforming		105		457		43		605
Total	$	27,775	$	63,727	$	3,925	$	95,427

Residential Mortgage Credit Exposure By Payment Activity:	Residential Mortgage						Total
Performing	$	227,448					$	227,448
Nonperforming		2,910						2,910
Total	$	230,358					$	230,358

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 through an allowance estimate or a charge-off to the allowance.

The following tables illustrate the recorded investment and number of modifications for modified loans, including the recorded investment in the loans prior to a modification and the recorded investment in the loans after restructuring for the three and six months ended June 30, 2016 and 2015:

	Three months ended June 30, 2016
	Number of contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Consumer
Home Equity		2	$	74	$	73
Total Consumer		2		74		73

Residential Real Estate		2		152		151

Total Troubled Debt Restructurings		4	$	226	$	224

	Three months ended June 30, 2015
	Number of contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Commercial
Commercial		1	$	1,165	$	1,165
Business Banking		1		190		176
Total Commercial		2		1,355		1,341

Consumer
Home Equity		12		1,071		1,128
Total Consumer		12		1,071		1,128

Residential Real Estate		6		370		770

Total Troubled Debt Restructurings		20	$	2,796	$	3,239

	Six months ended June 30, 2016
	Number of contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Consumer
Home Equity		14	$	1,109	$	1,017
Total Consumer		14		1,109		1,017

Residential Real Estate		6		683		578

Total Troubled Debt Restructurings		20	$	1,792	$	1,595

	Six months ended June 30, 2015
	Number of contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Commercial
Commercial		1	$	1,165	$	1,165
Business Banking		1		190		176
Total Commercial		2		1,355		1,341

Consumer
Home Equity		31		2,218		2,236
Total Consumer		31		2,218		2,236

Residential Real Estate		15		1,072		1,522

Total Troubled Debt Restructurings		48	$	4,645	$	5,099

There were no defaults on TDRs for the three months ended June 30, 2016 and 2015. The following table illustrates the recorded investment and number of modifications for TDRs within the six months ended June 30, 2016 and 2015 where a concession has been made and subsequently defaulted during the period:

	Six months ended June 30, 2016				Six months ended June 30, 2015
	Number of contracts		Recorded Investment		Number of contracts		Recorded Investment
Consumer
Home Equity		-	$	-		4	$	233

Residential Real Estate		1		175		-		-

Total Troubled Debt Restructurings		1	$	175		4	$	233