PRELIMINARY NOTE REGARDING
FORWARD-LOOKING STATEMENTS

Statements in this report that are not statements of historical fact are forward-looking statements. First Financial Service Corporation (the “Corporation”) may make forward-looking statements in future filings with the Securities and Exchange Commission (“SEC”), in press releases, and in oral and written statements made by or with the approval of the Corporation. Forward-looking statements include, but are not limited to: (1) projections of revenues, income or loss, earnings or loss per share, capital structure and other financial items; (2) plans and objectives of the Corporation or its management or Board of Directors; (3) statements regarding future events, actions or economic performance; and (4) statements of assumptions underlying such statements. Words such as “estimate,” “strategy,” “believes,” “anticipates,” “expects,” “intends,” “plans,” “targeted,” and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements.

Various risks and uncertainties may cause actual results to differ materially from those indicated by our forward-looking statements. In addition to those risks described under “Item 1A Risk Factors,” of this report, the following factors could cause such differences: changes in general economic conditions and economic conditions in Kentucky and the markets we serve, any of which may affect, among other things, our level of non-performing assets, charge-offs, and provision for loan loss expense; changes in interest rates that may reduce interest margins and impact funding sources; changes in market rates and prices which may adversely impact the value of financial products including securities, loans and deposits; changes in tax laws, rules and regulations; various monetary and fiscal policies and regulations, including those determined by the Federal Reserve Board, the Federal Deposit Insurance Corporation (“FDIC”) and the Kentucky Office of Financial Institutions (“KOFI”); competition with other local and regional commercial banks, savings banks, credit unions and other non-bank financial institutions; our ability to grow core businesses; our ability to develop and introduce new banking-related products, services and enhancements and gain market acceptance of such products; and management’s ability to manage these and other risks.

Our forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date of the statement to reflect the occurrence of unanticipated events.

PART I

Item 1. Business

First Financial Service Corporation was incorporated in August 1989 under Kentucky law and became the holding company for First Federal Savings Bank of Elizabethtown (the “Bank’), effective on June 1, 1990. Since that date, we have engaged in no significant activity other than holding the stock of the Bank and directing, planning and coordinating its business activities. Unless the text clearly suggests otherwise, references to “us,” “we,” or “our” include First Financial Service Corporation and its wholly owned subsidiary. Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank and its subsidiaries. In 2004 we amended our articles of incorporation to change our name from First Federal Financial Corporation of Kentucky to First Financial Service Corporation.

We are headquartered in Elizabethtown, Kentucky and were originally founded in 1923 as a state-chartered institution and became federally chartered in 1940. In 1987, we converted to a federally chartered savings bank and converted from mutual to stock form. We are a member of the FHLB of Cincinnati and, since converting to a state charter in 2003, have been subject to regulation, examination and supervision by the FDIC and the KOFI. Our deposits are insured by the Savings Association Insurance Fund (“SAIF”) and administered by the FDIC.

General Business Overview

We serve the needs and cater to the economic strengths of the local communities in which we operate and strive to provide a high level of personal and professional customer service. We offer a variety of financial services to our retail and commercial banking customers. These services include personal and corporate banking services and personal investment financial counseling services.

Our full complement of lending services includes:

· a broad array of residential mortgage products, both fixed and adjustable rate;

· consumer loans, including home equity lines of credit, auto loans, recreational vehicle, and other secured and unsecured loans;

· specialized financing programs to support community development;

· mortgages for multi-family real estate;

· commercial real estate loans;

· commercial loans to businesses, including revolving lines of credit and term loans;

· real estate development;

· construction lending; and

· agricultural lending.

We also provide a broad selection of deposit instruments. These include:

· multiple checking and NOW accounts for both personal and business accounts;

· various savings accounts, including those for minors;

· money market accounts;

· tax qualified deposit accounts such as Individual Retirement Accounts; and

· a broad array of certificate of deposit products.

We also support our customers by providing services such as:

· acting as a federal tax depository;

· providing access to merchant bankcard services;

· supplying various forms of electronic funds transfer;

· providing debit cards and credit cards; and

· providing telephone and Internet banking.

Through our personal investment financial counseling services, we offer a wide variety of mutual funds, equity investments, and fixed and variable annuities.

We invest in the wholesale capital markets through the management of our security portfolio and use various forms of wholesale funding. The security portfolio contains a variety of instruments, including callable debentures, taxable and non-taxable debentures, fixed and adjustable rate mortgage backed securities, and collateralized mortgage obligations.

Our results of operations depend primarily on net interest income, which is the difference between interest income from interest-earning assets and interest expense on interest-bearing liabilities. Our results

are also affected by non-interest income, such as service charges, insurance agency revenue, loan fees, gains and losses from the sale of mortgage loans and gains from the sale of real estate held for development. Our principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy costs, data processing expense and provisions for loan losses.

Market Area Served

We conduct operations in 14 full-service banking centers in six contiguous counties in Central Kentucky along the Interstate 65 corridor. Our markets range from the major metropolitan area of Louisville in Jefferson County, Kentucky approximately 40 miles north of our headquarters in Elizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles south of Elizabethtown. Our markets are supported by a diversified industry base and have a regional population of over 1 million. Louisville and Jefferson County comprise the 16th largest city in the United States. Our core markets have experienced a compound annual growth rate of 5% in deposits for the past five years. Management anticipates that our markets will continue to grow at a similar rate for the next few years and believes we are well positioned to benefit from this anticipated growth.

We operate in Hardin, Nelson, Hart, Bullitt, Meade and Jefferson Counties in Kentucky. Excluding Jefferson County, we control in the aggregate over 21% of the deposit market share with the next largest competitor controlling just 8% of the market. Over the past five years, these counties have demonstrated an average growth rate in deposits of 5%. According to the most recent census data, our core markets have experienced a population increase of 2%, a 6% increase in the median home price, and a growth in median family income of 4% over the past three census reporting years.

We expanded our presence into the Louisville market, primarily through our commercial lending operations. At December 31, 2006, over 22% of our total loan portfolio resides in this market. In an effort to better serve these customers and to enhance our retail branch network in this market, we opened two new full-service state of the art retail facilities in the second quarter of 2004. These facilities represent our state of the art prototype branch with a retail-focused design. This design features an internet café with access to online banking and bill payment services. Large plasma screens in the lobby provide customers with current news and information about bank products and services as well as upcoming community events. The facilities are staffed to offer a full range of financial services to the growing retail and commercial customer base. We plan on expanding our retail branch network in this market to ten branches over the next seven years. Our third Louisville Branch is expected to open in early 2007. We have a combined $39.1 million in deposits in these two facilities, representing a 30% increase in deposits in this market during 2006. Our current deposit market share in Louisville remains under 1% of the current $14.8 billion deposit base. Based on our service-focused operating strategy, we believe we can increase our presence in Louisville, where six large out-of-state holding companies hold the largest deposit market shares.

All of our market areas will likely benefit from the Fort Knox Military Base Realignment passed into law during 2006. Fort Knox is located in Hardin County, where we have a 21% market share. With the base realignment, Fort Knox will receive several additional military units including the Light Infantry Brigade Combat Team, the Combat Service Support Units and the Human Resource Command. These military units will bring an estimated 2,000 additional civilian positions and 3,000 additional military positions with an estimated $250 million in annual payroll to this area beginning in late 2008 through 2010. Over $700 million in renovations to Fort Knox are planned to accommodate these units, including the construction of approximately 800,000 square feet of office space to house the Human Resource Command. We anticipate the base realignment will result in substantial growth in the retail, housing, and service industries in our area. We plan to begin construction on a new branch facility at the main entrance to the Fort Knox Military Base during 2007 for completion in 2008. We have already experienced commercial loan growth

financing development and have active retail and commercial strategies prepared in anticipation of the new potential relationships arriving in our market area.

General and Operating Strategies

Our operating strategy is to serve the needs and cater to the economic strengths of the local communities in which we operate and strive to provide a high level of personal and professional customer service. We offer a variety of financial services to our retail and commercial banking customers.

Our growth strategy is focused on a combination of acquisitions and expansion in our existing markets through internal growth as well as establishing new branches.

Branch Expansion. Management continues to consider markets for branch expansion. Because of the economic growth in our markets over the past several years, we may consider further branch expansion in our current or surrounding market areas. However, we do not rule out branch expansion in other areas experiencing economic growth.

During 2006, we completed construction on a new full service-banking center in Elizabethtown and started construction on another facility in Louisville with plans of opening in early 2007. We are also considering other possible locations within our core market area as we continue to identify future branch sites. Negotiations continue on several locations, contingent upon successful rezoning efforts. Our expectation is to complete rezoning and begin construction on at least two facilities during 2007. Our goal is to protect and grow our 21% market share in Hardin County, where our core market is becoming increasingly competitive.

Internal Growth. Management believes that its largest source of internal growth is through our ongoing solicitation program conducted by branch managers and lending officers, followed by referrals from customers. The primary source for referrals is positive customer endorsements regarding our customer service and response time.

Our goal in continuing our expansion is to maintain a profitable, customer-focused financial institution. We believe that our existing structure, management, data and operational systems are sufficient to achieve further internal growth in asset size, revenues and capital without proportionate increases in operating costs. This growth should also allow us to increase the lending limits, thereby enabling us to increase our ability to serve the needs of existing and new customers. Our operating strategy has always been to provide high quality community banking services to our customers and increase market share through active solicitation of new business, repeat business and referrals from customers, and continuation of selected promotional strategies.

We believe that our banking customers seek a banking relationship with a service-oriented community banking organization. Our operational systems have been designed to facilitate personalized service. Management believes our banking locations have an atmosphere that encourages personalized services and decision-making, plus we are of sufficient financial size to offer broad product lines to meet customers’ needs. We also believe that economic expansion in our market areas will continue to contribute to internal growth. Through our primary emphasis on customer service and our management’s banking experience, we intend to continue internal growth by attracting customers and primarily focusing on the following:

· Products Offered—We offer personal and corporate banking services, mortgage origination, mortgage servicing, personal investment, and financial counseling services as well as internet and telephone banking. We offer a full range of commercial banking services, checking accounts, ATM’s, checking accounts with interest, savings accounts, money market accounts, certificates of deposit, NOW accounts, Individual Retirement Accounts, brokerage and residential mortgage services, branch banking, and debit and credit cards. We also offer installment loans, including auto,

recreational vehicle, and other secured and unsecured loans sourced directly by our branches. See “Lending Activities” below for a discussion of products we provide to commercial accounts.

· Operational Efficiencies—We seek to maximize operational and support efficiencies consistent with maintaining high quality customer service. Where feasible, we share a common information system designed to enhance customer service and improve efficiencies by providing system-wide voice and data communication connections. We have consolidated loan processing, bank balancing, financial reporting, investment management, information systems, payroll and benefit management, loan review, and audits.

· Marketing Activities—We focus on a proactive solicitation program for new business, as well as identifying and developing products and services that satisfy customer needs. We actively sponsor community events within our branch areas. We believe that active community involvement enhances our reputation and contributes to our long-term success.

Acquisitions. Management believes that the consolidation in the banking industries, along with the easing of restrictions on bank branching, as well as increased regulatory burdens, concerns about technology and marketing, are likely to lead owners of community banks and agencies within the Bank’s market areas to explore the possibility of sale or combination with a broader-based financial service companies such as ourselves.

In addition, branching opportunities have arisen from time to time as a result of divestiture of branches by large national and regional bank holding companies of certain overlapping branches resulting from consolidations. As a result, branch locations become available for purchase from time to time.

Management’s strategy in assimilating acquisitions is to emphasize revenue growth as well as to continuously review the operations of the acquired entities and streamline operations where feasible. Management does not believe that implementing wholesale administrative cost reductions in acquired institutions, particularly reducing customer focused personnel, is beneficial to our long-term growth, because significant administrative changes in community banks can have an adverse impact on customer satisfaction in the acquired institution’s community. However, management believes that certain human resource and accounting functions can be consolidated immediately upon acquisition to achieve higher productivity levels without compromising customer service. We emphasize revenue growth by offering customers a broader product line consistent with full service banking.

Management is very selective when evaluating a potential acquisition based upon factors such as the operating strategy, market, financial condition, and the culture of the acquisition candidate. The last acquisition we made was in July 1998 with the acquisition of three bank branches.

Lending Activities

Commercial Real Estate & Construction Lending. The largest portion of our lending activity is the origination of commercial loans that are primarily secured by real estate, including construction loans. We generate loans primarily in our market area. In recent years, we have put greater emphasis on originating loans for small and medium-sized businesses from our various locations. We make commercial loans to a variety of industries. Substantially all of the commercial real estate loans we originate have adjustable interest rates with maturities of 25 years or less or are loans with fixed interest rates and maturities of five years or less. At December 31, 2006, we had $410.1 million outstanding in commercial real estate loans. The security for commercial real estate loans includes retail businesses, warehouses, churches, apartment buildings and motels. In addition, the payment experience of loans secured by income producing properties typically depends on the success of the related real estate project and thus may be more vulnerable to adverse conditions in the real estate market or in the economy generally.

Loans secured by multi-family residential property, consisting of properties with more than four separate dwelling units, amounted to $20.1 million of the loan portfolio at December 31, 2006. These loans are included in the $410.1 million outstanding in commercial real estate loans discussed above. We generally do not lend above 75% of the appraised values of multi-family residences on first mortgage loans. The mortgage loans we currently offer on multi-family dwellings are generally one or five year ARMs with maturities of 25 years or less.

Construction loans involve additional risks because loan funds are advanced upon the security of the project under construction, which is of uncertain value before the completion of construction. The uncertainties inherent in estimating construction costs, delays arising from labor problems, material shortages, and other unpredictable contingencies, make it relatively difficult to evaluate accurately the total loan funds required to complete a project, and related loan-to-value ratios. The analysis of prospective construction loan projects requires significantly different expertise from that required for permanent residential mortgage lending. At December 31, 2006 we had $24.0 million outstanding in construction loans.

Our underwriting criteria are designed to evaluate and minimize the risks of each construction loan. Among other things, we consider evidence of the availability of permanent financing or a takeout commitment to the borrower; the reputation of the borrower and his or her financial condition; the amount of the borrower’s equity in the project; independent appraisals and cost estimates; pre-construction sale and leasing information; and cash flow projections of the borrower.

Commercial Business Lending. The commercial business loan portfolio has grown in recent years as a result of our focus on small business lending. We make secured and unsecured loans for commercial, corporate, business, and agricultural purposes, including issuing letters of credit and engaging in inventory financing and commercial leasing activities. Commercial loans generally are made to small-to-medium size businesses located within our defined market area. Commercial loans generally carry a higher yield and are made for a shorter term than real estate loans. Commercial loans, however, involve a higher degree of risk than residential real estate loans due to potentially greater volatility in the value of the assigned collateral, the need for more technical analysis of the borrower’s financial position, the potentially greater impact that changing economic conditions may have on the borrower’s ability to retire debt, and the additional expertise required for commercial lending personnel. Commercial business loans outstanding at December 31, 2006 totaled $40.9 million.

Residential Real Estate. Residential mortgage loans are secured primarily by single-family homes. The majority of our mortgage loan portfolio is secured by real estate in Hardin, Nelson, Hart, Meade, and Bullitt counties. Fixed rate residential real estate loans we originate have terms ranging from ten to thirty years. Interest rates are competitively priced within the primary geographic lending market, and vary according to the term for which they are fixed. At December 31, 2006 we had $137.3 million in residential mortgage loans outstanding.

We generally emphasize the origination of adjustable-rate mortgage loans (“ARMs”) when possible. We offer six ARM products with an annual adjustment, which is tied to a national index with a maximum adjustment of 2% annually, and a lifetime maximum adjustment cap of 6%. As of December 31, 2006, approximately 43.3% of our residential real estate loans were adjustable rate loans with adjustment periods ranging from one to five years and balloon loans of seven years or less. The origination of these ARMs can be more difficult in a low interest rate environment where there is a significant demand for fixed rate mortgages. We limit the maximum loan-to-value ratio on one-to-four-family residential first mortgages to 90% of the appraised value and generally limit the loan-to-value ratio on second mortgages on one-to-four-family dwellings to 90%.

Consumer Lending. Consumer loans include loans on automobiles, boats, recreational vehicles and other consumer goods, as well as loans secured by savings accounts, home improvement loans, and

unsecured lines of credit. As of December 31, 2006, consumer loans outstanding were $93.7 million. These loans involve a higher risk of default than loans secured by one-to-four-family residential loans. We believe, however, that the shorter term and the normally higher interest rates available on various types of consumer loans help maintain a profitable spread between the average loan yield and cost of funds. Home equity lines of credit as of December 31, 2006, totaled $36.6 million.

Our underwriting standards reflect the greater risk in consumer lending than in residential real estate lending. Among other things, the capacity of individual borrowers to repay can change rapidly, particularly during an economic downturn, collection costs can be relatively higher for smaller loans, and the value of collateral may be more likely to depreciate. Our Consumer Lending Policy establishes the appropriate consumer lending authority for all loan officers based on experience, training, and past performance for approving high quality loans. Loans beyond individual authorities must be approved by additional officers, the Executive Loan Committee or the Board of Directors, based on the size of the loan. We require detailed financial information and credit bureau reports for each consumer loan applicant to establish the applicant’s credit history, the adequacy of income for debt retirement, and job stability based on the applicant’s employment records. Co-signers are required for applicants who are determined marginal or who fail to qualify individually under these standards. Adequate collateral is required on the majority of consumer loans. The Executive Loan Committee monitors and evaluates unsecured lending activity by each loan officer.

The indirect consumer loan portfolio is comprised of new and used automobile, motorcycle and all terrain vehicle loans originated on our behalf by a select group of auto dealers within the service area. Indirect consumer loans are considered to have greater risk of loan losses than direct consumer loans due to, among other things: borrowers may have no existing relationship with us; borrowers may not be residents of the lending area; less detailed financial statement information may be collected at application; collateral values can be more difficult to determine; and the condition of vehicles securing the loan can deteriorate rapidly. To address the additional risks associated with indirect consumer lending, the Executive Loan Committee continually evaluates data regarding the dealers enrolled in the program, including monitoring turn down and delinquency rates. All applications are approved by specific lending officers, selected based on experience in this field, who obtain credit bureau reports on each application to assist in the decision. Aggressive collection procedures encourage more timely recovery of late payments. At December 31, 2006, total loans under the indirect consumer loan program totaled $30.9 million.

Subsidiary Activities

First Service Corporation of Elizabethtown (“First Service”), our licensed brokerage affiliate, provides investment services to our customers and offers tax-deferred annuities, government securities, mutual funds, and stocks and bonds. First Service employs four full-time employees. The net income of First Service was $20,465 for the year ended December 31, 2006.

First Federal Office Park, LLC, holds commercial lots adjacent to our home office on Ring Road in Elizabethtown, that are available for sale. We did not record any lot sales during the year ended December 31, 2006. Currently, we hold two of the original nine lots held for sale.

We provide title insurance coverage for mortgage borrowers through two subsidiaries: First Heartland Title, LLC, and First Federal Title Services, LLC. First Heartland Title is a joint venture with a local title insurance company and First Federal Title Services is a joint venture with a title insurance company in Louisville. We hold a 48% interest in First Heartland Title and a 49% interest in First Federal Title Services. The subsidiaries generated $121,200 in net income for the year ended December 31, 2006, of which our portion was $58,176.

In 2006, we dissolved First Heartland Mortgage Company of Elizabethtown, through which our secondary market lending department originated and sold qualified VA, KHC, RHC and conventional

secondary market loans. The employees of the First Heartland have been rolled back into the Bank. During 2006, our secondary market lending department originated $38.7 million in loans on behalf of investors. We do not service these loans after the sale.

Competition

We face substantial competition both in attracting and retaining deposits and in lending. Direct competition for deposits comes from commercial banks, savings institutions, and credit unions located in north-central Kentucky, and less directly from money market mutual funds and from sellers of corporate and government debt securities.

The primary competitive factors in lending are interest rates, loan origination fees and the range of services offered by the various financial institutions. Competition for origination of real estate loans normally comes from commercial banks, savings institutions, mortgage bankers, mortgage brokers, and insurance companies. Retail establishments effectively compete for loans by offering credit cards and retail installment contracts for the purchase of goods, merchandise and services (i.e., Home Depot, Lowe’s, etc). We believe that we have been able to compete effectively in our primary market area.

We have offices in nine cities in six central Kentucky counties. In addition to the financial institutions with offices in these counties, we compete with several commercial banks and savings institutions in surrounding counties, many of which have assets substantially greater than we have. These competitors attempt to gain market share through their financial product mix, pricing strategies, internet banking and banking center locations. In addition, Kentucky’s interstate banking statute, which permits banks in all states to enter the Kentucky market if they have reciprocal interstate banking statutes, has further increased competition for us. We believe that competition from both bank and non-bank entities will continue to remain strong in the near future.

The following table shows our market share and rank in terms of deposits in each Kentucky County where we have offices. We have two offices in Jefferson County, which is Louisville, Kentucky. The Louisville metropolitan area has a population of more than one million.

County	Number of Offices		FFKY Market Share %		FFKY Rank
Hardin		4		21.0		1
Nelson		2		8.0		5
Hart		1		17.0		3
Bullitt		2		26.0		1
Meade		3		55.0		1
Jefferson		2		<1.0		N/M

Employees

As of December 31, 2006, we had 277 employees, of which 262 were full-time and 15 part-time. None of our employees are subject to a collective bargaining agreement, and we believe that we enjoy good relations with our personnel.

Regulation

General Regulatory Matters. On January 8, 2003, we converted from a federally chartered savings bank to a Kentucky chartered commercial bank. Before the conversion, we were subject to the regulation of the Office of Thrift Supervision. As a Kentucky chartered commercial bank, we are now subject to supervision and regulation, which involves regular bank examinations, by both the FDIC and the KOFI. Our deposits are insured by the FDIC. Kentucky’s banking statutes contain a “super-parity” provision that permits a well-rated Kentucky bank to engage in any banking activity in which a national bank operating in any state, a state bank, thrift or savings bank operating in any other state, or a federally chartered thrift or

federal savings association meeting the qualified thrift lender test and operating in any state could engage, provided the Kentucky bank first obtains a legal opinion specifying the statutory or regulatory provisions that permit the activity.

In connection with the conversion, we registered to become a bank holding company under the Bank Holding Company Act of 1956, and are subject to supervision and regulation by the Federal Reserve Board. As a bank holding company, we are required to file with the Federal Reserve Board annual and quarterly reports and other information regarding our business operations and the business operations of our subsidiaries. We are also subject to examination by the Federal Reserve Board and to its operational guidelines. We are subject to the Bank Holding Company Act and other federal laws on the types of activities in which we may engage, and to other supervisory requirements, including regulatory enforcement actions for violations of laws and regulations.

Acquisitions and Change in Control. As a bank holding company, we must obtain Federal Reserve Board approval before acquiring, directly or indirectly, ownership or control of more than 5% of the voting stock of a bank, and before engaging, or acquiring a company that is not a bank but is engaged in certain non-banking activities. In approving these acquisitions, the Federal Reserve Board considers a number of factors, and weighs the expected benefits to the public such as greater convenience, increased competition and gains in efficiency, against the risks of possible adverse effects such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The Federal Reserve Board also considers the financial and managerial resources of the bank holding company, its subsidiaries and any company to be acquired, and the effect of the proposed transaction on these resources. It also evaluates compliance by the holding company’s financial institution subsidiaries and the target institution with the Community Reinvestment Act. The Community Reinvestment Act generally requires each financial institution to take affirmative action to ascertain and meet the credit needs of its entire community, including low and moderate income neighborhoods.

Federal law also prohibits a person or group of persons from acquiring “control” of a bank holding company without notifying the Federal Reserve Board in advance, and then only if the Federal Reserve Board does not object to the proposed transaction. The Federal Reserve Board has established a rebuttable presumptive standard that the acquisition of 10% or more of the voting stock of a bank holding company with a class of securities registered under the Securities Exchange Act of 1934 (the “Exchange Act”) would constitute an acquisition of control of the bank holding company. In addition, any company is required to obtain the approval of the Federal Reserve Board before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of any class of a bank holding company’s voting securities, or otherwise obtaining control or a “controlling influence” over a bank holding company.

Other Financial Activities. The Gramm-Leach-Bliley Act of 1999 permits a bank holding company to elect to become a financial holding company, which permits the holding company to conduct activities that are “financial in nature.” To become and maintain its status as a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well managed, and have at least a satisfactory Community Reinvestment Act rating. We have not filed an election to become a financial holding company.

Other Holding Company Regulations. Federal law substantially restricts transactions between financial institutions and their affiliates. As a result, a bank is limited in extending credit to its holding company (or any non-bank subsidiary), in investing in the stock or other securities of the bank holding company or its non-bank subsidiaries, and/or in taking such stock or securities as collateral for loans to any borrower. Moreover, transactions between a bank and a bank holding company (or any non-bank subsidiary) must generally be on terms and under circumstances at least as favorable to the bank as those prevailing in comparable transactions with independent third parties or, in the absence of comparable transactions, on terms and under circumstances that in good faith would be available to nonaffiliated companies.

Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to, and to commit resources to support, its bank subsidiaries. This support may be required at times when, absent such a policy, the bank holding company may not be inclined to provide it. In addition, any capital loans by the bank holding company to its bank subsidiaries are subordinate in right of payment to deposits and to certain other indebtedness of the bank subsidiary. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of subsidiary banks will be assumed by the bankruptcy trustee and entitled to a priority of payment.

Capital Requirements. The Federal Reserve Board and the FDIC have substantially similar risk-based and leverage capital guidelines applicable to the banking organizations they supervise. Under the risk-based capital requirements, we are generally required to maintain a minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) of 8%. At least half of the total capital must be composed of common equity, retained earnings and qualifying perpetual preferred stock and certain hybrid capital instruments, less certain intangibles (“Tier 1 capital”). The remainder may consist of certain subordinated debt, certain hybrid capital instruments, qualifying preferred stock and a limited amount of the loan loss allowance (“Tier 2 capital” which, together with Tier 1 capital, composes “total capital”). To be considered well-capitalized under the risk-based capital guidelines, an institution must maintain a total risk-weighted capital ratio of at least 10% and a Tier 1 risk-weighted ratio of 6% or greater. For further information, see “Item 7-Management’s Discussion and Analysis of Financial Condition and Results of Operations-Capital.”

The Federal Deposit Insurance Corporation Act of 1991 (“FDICIA”), among other things, identifies five capital categories for insured depository institutions: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. The Corporation and the Bank are classified as “well-capitalized.” FDICIA also requires the bank regulatory agencies to implement systems for “prompt corrective action” for institutions that fail to meet minimum capital requirements within these five categories, with progressively more severe restrictions on operations, management and capital distributions according to the category in which an institution is placed. Failure to meet capital requirements can also cause an institution to be directed to raise additional capital. FDICIA also mandates that the agencies adopt safety and soundness standards relating generally to operations and management, asset quality and executive compensation, and authorizes administrative action against an institution that fails to meet such standards.

In addition, the Federal Reserve Board and the FDIC have each adopted risk-based capital standards that explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution’s ability to manage these risks, as important factors to be taken into account by each agency in assessing an institution’s overall capital adequacy. The capital guidelines also provide that an institution’s exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization’s capital adequacy. In addition to the “prompt corrective action” directives, failure to meet capital guidelines can subject a banking organization to a variety of other enforcement remedies, including additional substantial restrictions on its operations and activities, termination of deposit insurance by the FDIC, and under some conditions the appointment of a conservator or receiver.

Deposit Insurance. Our deposits are insured by the FDIC up to the statutory maximum limit of $100,000 per depositor through SAIF. For this protection, we must pay semiannual assessments to the FDIC. The assessment rate for an insured depository institution depends on the assessment risk classification assigned to the institution by the FDIC, which will be determined by the institution’s capital level and supervisory evaluations.

Dividends. The Corporation is a legal entity separate and distinct from the Bank. The majority of our revenue is from dividends we receive from the Bank. The Bank is subject to laws and regulations that limit the amount of dividends it can pay. If, in the opinion of a federal regulatory agency, an institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice, the agency may require, after notice and hearing, that the institution cease and desist from such practice. The federal banking agencies have indicated that paying dividends that deplete an institution’s capital base to an inadequate level would be an unsafe and unsound banking practice. Under FDICIA, an insured institution may not pay a dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. Moreover, the Federal Reserve and the FDIC have issued policy statements providing that bank holding companies and banks should generally pay dividends only out of current operating earnings.

Under Kentucky law, dividends by Kentucky banks may be paid only from current or retained net profits. Before any dividend may be declared for any period (other than with respect to preferred stock), a bank must increase its capital surplus by at least 10% of the net profits of the bank for the period until the bank’s capital surplus equals the amount of its stated capital attributable to its common stock. Moreover, the KOFI Commissioner must approve the declaration of dividends if the total dividends to be declared by a bank for any calendar year would exceed the bank’s total net profits for such year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of preferred stock or debt. We are also subject to the Kentucky Business Corporation Act, which generally prohibits dividends to the extent they result in the insolvency of the corporation from a balance sheet perspective or if becoming unable to pay debts as they come due.

Consumer Protection Laws. We are subject to a number of federal and state laws designed to protect borrowers and promote lending to various sectors of the economy and population. These laws include the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Home Mortgage Disclosure Act, and the Real Estate Settlement Procedures Act, and state law counterparts.

Federal law currently contains extensive customer privacy protections provisions. Under these provisions, a financial institution must provide to its customers, at the inception of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. These provisions also provide that, except for certain limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. Federal law makes it a criminal offense, except in limited circumstances, to obtain or attempt to obtain customer information of a financial nature by fraudulent or deceptive means.

The Community Reinvestment Act (“CRA”) requires the FDIC to assess our record in meeting the credit needs of the communities we serve, including low- and moderate-income neighborhoods and persons. The FDIC’s assessment of our record is made available to the public. The assessment also is part of the Federal Reserve Board’s consideration of applications to acquire, merge or consolidate with another banking institution or its holding company, to establish a new branch office or to relocate an office. The Federal Reserve Board will also assess the CRA record of the subsidiary banks of a bank holding company in its consideration of any application to acquire a bank or other bank holding company, which may be the basis for denying the application.

Bank Secrecy Act. The Bank Secrecy Act of 1970 (“BSA”) was enacted to deter money laundering, establish regulatory reporting standards for currency transactions and improve detection and investigation of criminal, tax and other regulatory violations. BSA and subsequent laws and regulations require us to take steps to prevent the use of the Bank in the flow of illegal or illicit money, including, without limitation,

ensuring effective management oversight, establishing sound policies and procedures, developing effective monitoring and reporting capabilities, ensuring adequate training and establishing a comprehensive internal audit of BSA compliance activities.

In recent years, federal regulators have increased the attention paid to compliance with the provisions of BSA and related laws, with particular attention paid to “Know Your Customer” practices. Banks have been encouraged by regulators to enhance their identification procedures prior to accepting new customers in order to deter criminal elements from using the banking system to move and hide illegal and illicit activities.

USA Patriot Act. The USA PATRIOT Act of 2001 (the “Patriot Act”) contains anti-money laundering measures affecting insured depository institutions, broker-dealers and certain other financial institutions. The Patriot Act requires financial institutions to implement policies and procedures to combat money laundering and the financing of terrorism, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. The Patriot Act also grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on financial institutions’ operations. In addition, the Patriot Act requires the federal bank regulatory agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions.

Available Information

We file annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports with the Securities and Exchange Commission. These reports are available at the SEC’s website at http://www.sec.gov. The reports are also available on our website at http://www.ffsbky.com. You may obtain electronic or paper copies of our reports free of charge by contacting Janelle Poppe, Corporate Secretary-Treasurer, First Federal Savings Bank, 2323 Ring Road, Elizabethtown, Kentucky 42701 (telephone) 270-765-2131.

Item 1A. Risk Factors

We, like other financial companies, are subject to a number of risks, many of which are outside of our management’s control. We strive to manage risks while optimizing returns. The principal risks that affect our business are: (a) credit risk, which is the risk that loan and lease customers or other counterparties will be unable to perform their contractual obligations, (b) market risk, which is the risk that changes in market rates and prices will adversely affect our financial condition or results of operation, (c) liquidity risk, which is the risk that we will have insufficient cash or access to cash to meet our operating needs, and (d) operational risk, which is the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events.

The risks identified below, as well as in the other cautionary statements made throughout this report, identify factors that could materially and adversely affect our business, future results of operations, and future cash flows.

Credit Risk

We extend credit to a variety of customers based on internally set standards and the judgment of management. We manage the credit risk it takes through a program of underwriting standards that we follow, the review of certain credit decisions, and an on-going process of assessment of the quality of the credit we have already extended. If our credit standards and our on-going process of credit assessment do not function as intended, we could incur significant credit losses.

Our loans and deposits are focused in central Kentucky. Adverse economic conditions in that region, in particular, could harm our results from operations, cash flows, and financial condition. Adverse economic conditions and other factors, such as legislative or business developments or natural hazards that may affect Kentucky, may reduce demand for credit or fee-based products and could negatively affect real estate and other collateral values, interest rate levels, and the availability of credit to refinance loans at or before maturity.

Market Risk

Changes in interest rates could harm our financial condition or results of operations. Our results of operations depend substantially on net interest income, the difference between interest earned on interest-earning assets (such as investments and loans) and interest paid on interest-bearing liabilities (such as deposits and borrowings). Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions. Factors beyond our control, such as inflation, recession, unemployment, and money supply may also affect interest rates. If our interest-earning assets mature or reprice more quickly than our interest-bearing liabilities in a given period, as a result of decreasing interest rates, our net interest income may decrease. Likewise, our net interest income may decrease if interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period as a result of increasing interest rates.

Fixed-rate loans increase our exposure to interest rate risk in a rising rate environment because interest-bearing liabilities would be subject to repricing before assets become subject to repricing. Adjustable-rate loans decrease the risk associated with changes in interest rates but involve other risks, such as the inability of borrowers to make higher payments in an increasing interest rate environment. At the same time, for secured loans, the marketability of the underlying collateral may be adversely affected by higher interest rates. In a declining interest rate environment, there may be an increase in prepayments on loans as the borrowers refinance their loans at lower interest rates, which could reduce net interest income and harm our results of operations.

Liquidity Risk

If we cannot borrow funds through access to the capital markets, we may not be able to meet the cash flow requirements of our depositors and borrowers, or meet the operating cash needs of the Corporation to fund corporate expansion or other activities. Our liquidity policies and limits are established by the Board of Directors, with operating limits set by the Asset Liability Committee (“ALCO”), based upon analyses of the ratio of loans to deposits, the percentage of assets funded with non-core or wholesale funding. The ALCO regularly monitors the overall liquidity position of the Bank and the Corporation to ensure that various alternative strategies exist to cover unanticipated events that could affect liquidity. Liquidity is the ability to meet cash flow needs on a timely basis at a reasonable cost. If our liquidity policies and strategies don’t work as well as intended, then we may be unable to make loans and to repay deposit liabilities as they become due or are demanded by customers. The ALCO follows established board approved policies and monitors guidelines to diversify our wholesale funding sources to avoid concentrations in any one-market source. Wholesale funding sources include Federal funds purchased, securities sold under repurchase agreements, non-core brokered deposits, and medium and long-term debt, which includes Federal Home Loan Bank (“FHLB”) advances that are collateralized with mortgage-related assets.

We maintain a portfolio of securities that can be used as a secondary source of liquidity. There are other available sources of liquidity, including the sale or securitization of loans, the ability to acquire additional non-core brokered deposits, additional collateralized borrowings such as FHLB advances, the issuance of debt securities, and the issuance of preferred or common securities in public or private transactions. If we were unable to access any of these funding sources when needed, we might not be able to meet the needs of our customers, which could adversely impact our financial condition, our results of

operations, cash flows, and our level of regulatory-qualifying capital. For further discussion, see the “Liquidity” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Operational Risk

We have significant competition in both attracting and retaining deposits and in originating loans. Competition is intense in most of the markets we serve. We compete on price and service with other banks and financial companies such as commercial banks, savings institutions, credit unions, finance companies, insurance companies, mortgage banking companies, and brokerage firms. Competition could intensify in the future as a result of industry consolidation, the increasing availability of products and services from non-banks, greater technological developments in the industry, and banking reform. If our competition prices deposits or loans at rates significantly more favorable than ours, then we may have difficulty in both attracting and retaining deposits and loans.

Management maintains internal operational controls and we have invested in technology to help us process large volumes of transactions. However, there can be no assurance that we will be able to continue processing at the same or higher levels of transactions. If our systems of internal controls should fail to work as expected, if our systems were to be used in an unauthorized manner, or if employees were to subvert the system of internal controls, significant losses could occur.

We process large volumes of transactions on a daily basis and are exposed to numerous types of operation risk, which could cause us to incur substantial losses. Operational risk resulting from inadequate or failed internal processes, people, and systems includes the risk of fraud by employees or persons outside of our company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, and breaches of the internal control system and compliance requirements. This risk of loss also includes potential legal actions that could arise as a result of the operational deficiency or as a result of noncompliance with applicable regulatory standards.

We establish and maintain systems of internal operational controls that provide management with timely and accurate information about our level of operational risk. While not foolproof, these systems have been designed to manage operational risk at appropriate, cost effective levels. We have also established procedures that are designed to ensure that policies relating to conduct, ethics, and business practices are followed. From time to time, we experience loss from operational risk, including the effects of operational errors, and these losses may be substantial.

While management continually monitors and improves our system of internal controls, data processing systems, and corporate wide processes and procedures, there can be no assurance that we will not suffer such losses in the future. New, or changes in existing tax, accounting, are regulatory laws, regulations, rules, standards, policies, and interpretations could significantly impact strategic initiatives, results of operations, cash flows, and financial condition.

The financial services industry is extensively regulated. Federal and state banking regulations are designed primarily to protect deposit insurance funds and consumers, not to benefit a financial company’s shareholders. These regulations may sometimes impose significant limitations on operations. The significant federal and state banking regulations that affect us are described in this report under the heading “Regulation.” These regulations, along with currently existing tax, accounting, and monetary laws, regulations, rules, standards, policies and interpretations control the methods by which financial institutions conduct business, implement strategic initiatives and tax compliance, and govern financial reporting and disclosures. These laws, regulations, rules, standards, policies, and interpretations are constantly evolving and may change significantly over time. Events that may not have a direct impact on us, such as the bankruptcy of U.S. companies, can cause legislators, regulators, and authoritative bodies, such as the Financial Accounting Standards Board, the SEC, the Public Company Accounting Oversight Board, and other various taxing authorities to respond by adopting and or proposing substantive revisions to laws,

regulations, rules, standards, policies, and interpretations. The nature, extent, and timing of the adoption of significant new laws and regulations, or changes in or repeal of existing laws and regulations may have a material impact on our business and results of operations. Changes in regulation may cause us to devote substantial additional financial resources and management time to compliance, which may negatively affect our operating results.

Item 1B. Unresolved Staff Comments

Not applicable

Item 2. Properties

Our executive offices, principal support and operational functions are located at 2323 Ring Road in Elizabethtown, Kentucky. All of our banking centers are located in Kentucky. The location of the 14 banking centers, whether owned or leased, and their respective approximate square footage is described in the following table.

			Approximate
	Owned or		Square
Banking Centers	Leased		Footage
ELIZABETHTOWN
2323 Ring Road		Owned		57,295
325 West Dixie Avenue		Owned		5,880
2101 North Dixie Avenue		Owned		3,150
RADCLIFF
475 West Lincoln Trail		Owned		2,728
BARDSTOWN
401 East John Rowan Blvd.		Leased		4,500
315 North Third Street		Owned		1,271
MUNFORDVILLE
925 Main Street		Owned		2,928
SHEPHERDSVILLE
395 N. Buckman Street		Owned		7,600
MT. WASHINGTON
279 Bardstown Road		Owned		6,310
BRANDENBURG
416 East Broadway		Leased		4,395
50 Old Mill Road		Leased		575
FLAHERTY
4055 Flaherty Road		Leased		1,216
LOUISVILLE
11810 Interchange Drive		Owned		4,675
3650 South Hurstbourne Parkway		Owned		4,428

Item 3. Legal Proceedings

Although, from time to time, we are involved in various legal proceedings in the normal course of business, there are no material pending legal proceedings to which we are a party, or to which any of our property is subject.

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted for shareholder approval during the fourth quarter of 2006.

PART II

Item 5. Market Price of and Dividends on the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

(a) Market Information

Our Common Stock is traded on the NASDAQ Global Market (NASDAQ) under the symbol “FFKY”. The following table shows the high and low closing prices of our Common Stock and the dividends paid.

	Quarter Ended
2006:(1)	3/31		6/30		9/30		12/31
High	$	27.27	$	28.12	$	31.52	$	31.89
Low	25.03		26.59		27.50		30.10
Cash dividends	0.173		0.173		0.190		0.190

2005:(1)	3/31		6/30		9/30		12/31
High	$	20.32	$	20.68	$	22.26	$	26.35
Low	19.42		19.05		20.65		23.55
Cash dividends	0.157		0.157		0.157		0.173

(1) Adjusted to reflect the impact of stock dividends declared August 15, 2006 and September 20, 2005.

(b) Holders

At December 31, 2006, the number of shareholders was approximately 1,128.

(c) Dividends

It is currently the policy of our Board of Directors to continue to pay quarterly dividends, but any future dividends are subject to the Board’s discretion based on its consideration of the our operating results, financial condition, capital, income tax considerations, regulatory restrictions and other factors.

(d) Securities Authorized for Issuance Under Equity Compensation Plans

Number of securities

remaining available for

to be issued

Weighted-average

future issuance under

upon exercise of

exercise price of

equity compensation plans

outstanding options,

(excluding securities

Plan category

warrants and rights

reflected in column(1))

Equity compensation plans approved by security holders

169,160

20.35

562,500

Equity compensation plans not approved by security holders

—

Total

169,160

20.35

562,500

See Note 11 of the Notes to Consolidated Financial Statements for additional information required by this item.

(e) Issuer Purchases of Equity Securities

						Total Number of		Maxium
	Total		Average			Shares Purchased		Number of Shares
	Number		Price			as Part of		that May Yet Be
	of Shares		Paid			Publicly Announced		Purchased Under
Period	Purchased		per Share			Plans		the Plan
October 1-October 31		—		—			—		398,601
November 1-November 30		500		$	31.00		500		398,101
December 1-December 31		—		—			—		398,101
Total		500		$	31.00		500

Item 6. Selected Consolidated Financial and Other Data

	At December 31,										At June 30,
Financial Condition Data:	2006		2005		2004		2003		2002		2002
Total assets	$	822,826	$	766,513	$	737,646	$	676,335	$	670,728		$	679,395
Net loans outstanding(1)	698,026		635,740		599,428		550,153		528,535			520,261
Interest bearing deposits	—		—		—		—		—			64,000
Investments	52,447		61,555		56,843		34,938		18,575			23,693
Deposits	641,037		591,106		586,386		529,162		521,121			529,882
Borrowings	106,724		107,875		88,904		88,283		87,683			87,778
Stockholders’ equity	72,098		64,741		59,801		56,321		59,647			58,615
Number of:
Real estate loans outstanding	11,015		10,130		9,358		8,028		7,156			7,577
Deposit accounts	53,165		50,790		48,637		48,443		49,210			49,726
Offices	14		14		14		13		13			13
Full time equivalent employees	270		254		246		237		219			209

													Six Months
													Ended				Year Ended
	Year Ended December 31,												December 31,				June 30,
Operations Data:	2006			2005			2004			2003			2002				2002
Interest income	$	53,832		$	45,368		$	39,143		$	39,339			$	21,556			$	44,100
Interest expense	24,108			17,862			14,792			16,365				9,394				21,426
Net interest income	29,724			27,506			24,351			22,974				12,162				22,674
Provision for loan losses	540			1,258			1,656			1,656				1,161				1,604
Non-interest income	7,739			8,067			8,104			7,981				3,177				5,398
Non-interest expense	21,952			20,759			19,274			17,292				7,597				15,281
Income tax expense	4,634			4,412			3,735			4,004				2,199				3,729
Net income	10,337			9,144			7,790			8,003				4,382				7,458
Earnings per share:(2)
Basic	$	2.36		$	2.08		$	1.76		$	1.75			$	0.90			$	1.50
Diluted	2.34			2.07			1.75			1.73				0.89				1.49
Book value per share(2)	16.45			14.77			13.55			12.56				12.30				11.81
Dividends paid per share(2)	0.73			0.64			0.61			0.58				0.27				0.54
Dividend payout ratio	31		%	31		%	35		%	33		%		30		%		36		%
Return on average assets	1.31		%	1.22		%	1.12		%	1.18		%		1.31		%		1.19		%
Average equity to average assets	8.71		%	8.33		%	8.28		%	8.26		%		8.77		%		9.10		%
Return on average equity	15.03		%	14.60		%	13.47		%	14.32		%		14.89		%		13.08		%
Efficiency ratio	59		%	58		%	59		%	56		%		50		%		54		%

(1) Includes loans held for sale.

(2) Amounts adjusted to reflect 10% stock dividends declared April 16, 2003, September 20, 2005, and August 15, 2006.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of our balance sheets and statements of income. This section should be read in conjunction with our Consolidated Financial Statements and accompanying Notes and other detailed information.

OVERVIEW

We conduct operations in 14 full-service banking centers in six contiguous counties in Central Kentucky along the Interstate 65 corridor. Our markets range from the major metropolitan area of Louisville in Jefferson County, Kentucky approximately 40 miles north of our headquarters in Elizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles south of Elizabethtown. Our core markets have experienced a compound annual growth rate of 5% in deposits for the past five years. We anticipate that our markets will continue to grow at a similar rate for the next few years and believe we are well positioned to benefit from this anticipated growth.

Over the past several years we have focused on enhancing and expanding our retail and commercial banking network in our core markets as well as establishing our presence in the Louisville market. Our core markets, where we have a combined 21% market share, have become increasingly competitive as several new banks have entered the five counties other than Louisville/Jefferson County in the past few years. In order to protect and grow our market share, we replaced existing branches with newer, enhanced facilities and anticipate constructing several new facilities over the next few years. In addition to the enhancement and expansion in our core markets, we have been increasing our presence in the Louisville market. Approximately 75% of the deposit base in the Louisville market is controlled by six out-of-state banks. While the market is very competitive, we believe this creates an opportunity for smaller community banks with more power to make decisions locally. We believe our investment in these initiatives along with our continued commitment to a high level of customer service will enhance our market share in our core markets and our development in the Louisville market.

Our retail branch network continues to generate encouraging results. Total deposits have grown at a 5% compound annual growth rate over the past five years. Total deposits were $641 million at December 31, 2006, an increase of $50 million, or 8% for the year. The continued development of the retail branch network into the Louisville market also yielded positive results. We have a combined $39.1 million in deposits in our two full-service facilities in the Louisville market representing a 30% increase in deposits for the year. We opened these facilities in the second quarter of 2004 to support our growing customer base in this market and have started construction on a new full service-banking center in the Louisville market with plans of opening in early 2007.

We have developed a strong commercial real estate niche in our markets. We have an experienced team of bankers who are focused on providing service and convenience to our customers. It is quite common for our bankers to close loans at a customer’s place of business or even the customer’s personal residence. This high level of service has been especially well received in our Louisville market, which is dominated by regional banks. Currently, twenty-two percent of our loan portfolio resides in the Louisville market. To further develop our commercial banking relationships in Louisville, we anticipate opening a private banking office in early 2007. This office will be an upscale facility complementing our retail branch network in Louisville allowing us to further attract commercial deposit relationships in conjunction with our commercial lending relationships.

This emphasis on commercial lending generated an 8% compound annual growth rate in the total loan portfolio and a 20% compound annual growth rate in commercial loans over the past three years. Commercial loans were $475 million at December 31, 2006, an increase of $71.8 million, or 18%, from December 31, 2005. Commercial checking balances were $36.7 million at December 31, 2006. We have experienced a 14% compound annual growth rate in commercial checking accounts over the past three years.

The growth in our commercial and commercial real estate loan portfolio, coupled with our efforts to fund these loans with lower cost customer deposits is our primary business model and has substantially contributed to the growth in earnings over the past several years.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

Our accounting and reporting policies comply with U.S. generally accepted accounting principles and conform to general practices within the banking industry. The accounting policy relating to the allowance for loan losses is critical to the understanding of our results of operations since the application of this policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were to change.

Allowance for Loan Losses—We maintain an allowance sufficient to absorb probable incurred credit losses existing in the loan portfolio. The Allowance for Loan Loss Review Committee evaluates the allowance for loan losses on a quarterly basis. We estimate the allowance using past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of the underlying collateral, and current economic conditions. While we estimate the allowance for loan losses based in part on historical losses within each loan category, estimates for losses within the commercial and commercial real estate portfolio are more dependent upon credit analysis and recent payment performance. Allocations of the allowance may be made for specific loans or loan categories, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.

The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors. The methodology for allocating the allowance for loan and lease losses takes into account our strategic plan to increase our emphasis on commercial and consumer lending. We increase the amount of the allowance allocated to commercial loans and consumer loans in response to the growth of the commercial and consumer loan portfolios and management’s recognition of the higher risks and loan losses in these lending areas. Allowance estimates are developed with actual loss experience adjusted for current economic conditions. Allowance estimates are considered a prudent measurement of the risk in the loan portfolio and are applied to individual loans based on loan type.

Based on our calculation, an allowance of $7.7 million or 1.09% of total loans was our estimate of probable losses within the loan portfolio as of December 31, 2006. This estimate resulted in a provision for loan losses on the income statement of $540,000 for 2006. If the mix and amount of future charge off percentages differ significantly from those assumptions used by management in making its determination, the allowance for loan losses and provision for loan losses on the income statement could be materially affected.

RESULTS OF OPERATION

Net income for the period ended December 31, 2006 was $10.3 million or $2.34 per share diluted compared to $9.1 million or $2.07 per share diluted for the same period in 2005. The increase was primarily the result of an increase in net interest income of $2.2 million and a decrease in provision for loan loss expense of $718,000. Our book value per common share increased from $14.77 at December 31, 2005 to $16.45 at December 31, 2006. Net income for 2006 generated a return on average assets of 1.31% and a return on average equity of 15.03%. These compare with a return on average assets of 1.22% and a return on average equity of 14.60% for the 2005 period.

Net income for the period ended December 31, 2005 was $9.1 million or $2.07 per share diluted compared to $7.8 million or $1.75 per share diluted for the same period in 2004. The increase was

primarily the result of an increase in net interest income of $3.2 million and a decrease in provision for loan loss expense of $398,000. Our book value per common share increased from $13.55 at December 31, 2004 to $14.77 at December 31, 2005. Net income for 2005 generated a return on average assets of 1.22% and a return on average equity of 14.60%. These compare with a return on average assets of 1.12% and a return on average equity of 13.47% for the 2004 period.

Net Interest Income—The principal source of our revenue is net interest income. Net interest income is the difference between interest income on interest-earning assets, such as loans and securities and the interest expense on liabilities used to fund those assets, such as interest-bearing deposits and borrowings. Net interest income is impacted by both changes in the amount and composition of interest-earning assets and interest-bearing liabilities as well as changes in market interest rates.

Net interest margin as a percent of average earning assets increased 11 basis points to 4.04% for the year ended December 31, 2006 compared to 3.93% for the 2005 period. An increase in short-term interest rates and an increase in average earning assets improved net interest income for the periods presented. Average interest earning assets increased $38.4 million for the 2006 period compared to 2005. The yield on earning assets averaged 7.30% for the 2006 period compared to an average yield on earning assets of 6.48% for the same period in 2005. The prime-lending rate increased 75 basis points during 2006 and the increase has favorably impacted the yield on earning assets for the year.

Our cost of funds averaged 3.58% for the 2006 period compared to an average cost of funds of 2.77% for the same period in 2005. Deposit costs have accelerated due to the re-pricing of maturing certificates of deposit that roll off into certificates of deposit at currently higher interest rates as well as to our paying higher rates on our money market products. Going forward, our cost of funds is expected to increase as interest rates paid on deposit products have become increasingly competitive with the recent upward trend in interest rates.

Net interest margin was also impacted during 2006 by the conversion of a fixed rate FHLB advance. During January 2001, we entered into a $50.0 million convertible fixed rate advance with a maturity of ten years. This advance was fixed for a period of two years. At the end of the fixed rate term and quarterly thereafter, the FHLB had the right to convert this advance to a variable rate advance tied to the three-month LIBOR index. Upon conversion, we could prepay the advance at no penalty. This advance, fixed at a rate of 4.86%, was converted and paid off in July 2006, at a rate of 5.25% without penalty. We replaced the borrowing with overnight short-term borrowings, which averaged a rate of 5.31% during the year. These borrowings will continue to float at an overnight rate until we replace the borrowings with deposits or other fixed rate and term borrowings. For the next several quarters, we anticipate maintaining the borrowings at a floating rate. This floating rate will better match the variable rate commercial and commercial real estate loans in our loan portfolio and therefore reduce the volatility of net interest margin with future interest rate movements.

The net result of the above factors was an increase in net interest income of $2.2 million for the year ended December 31, 2006 compared to 2005. The net interest margin is likely to compress in future quarters as short term interest rates peak and the cost of deposits continue to rise. The cost of deposits typically lags behind the increase in adjustable rate loans because certificates of deposit generally mature over longer periods than immediately adjustable rate loans.

Comparative information regarding net interest income follows:

										2006/2005			2005/2004
	2006			2005			2004			Change			Change
	(Dollars in thousands)
Net interest income, tax equivalent basis	$	53,987		$	45,431		$	39,165			18.8	%		16.0	%
Net interest spread	3.72		%	3.71		%	3.58		%		1	bp		13	bp
Net interest margin	4.04		%	3.93		%	3.76		%		11	bp		17	bp
Average earnings assets	$	739,215		$	700,849		$	648,703			5.5	%		8.0	%
Prime rate at year end	8.25		%	7.25		%	5.25		%		100	bp		200	bp
Average prime rate	7.98		%	6.19		%	4.34		%		179	bp		185	bp

bp = basis point = 1/100th of a percent

Prime rate is included above to provide a general indication of the interest rate environment in which we operate. A large portion of our variable rate loans were indexed to the prime rate and re-price as the prime rate changes, unless they reach a contractual floor or ceiling.

AVERAGE BALANCE SHEETS

The following table provides information relating to our average balance sheet and reflects the average yield on assets and average cost of liabilities for the indicated periods. Yields and costs for the periods presented are derived by dividing income or expense by the average monthly balance of assets or liabilities, respectively.

	Year Ended December 31,
	2006								2005								2004
	Average					Average			Average					Average			Average					Average
	Balance			Interest		Yield/Cost			Balance			Interest		Yield/Cost			Balance			Interest		Yield/Cost
	(Dollars in thousands)
ASSETS
Interest earning assets:
U.S. Treasury and agencies	$	27,823		$	891		3.20	%	$	48,063		$	1,319		2.74	%	$	26,761		$	728		2.72	%
Mortgage-backed securities	14,832			631			4.25	%	12,714			516			4.06	%	9,343			352			3.77	%
Equity securities	1,974			73			3.70	%	2,063			93			4.51	%	3,215			124			3.86	%
State and political subdivision securities(1)	7,134			459			6.43	%	2,971			186			6.26	%	1,058			67			6.33	%
Corporate bonds	6,047			413			6.83	%	3,547			181			5.10	%	2,000			66			3.30	%
Loans(2)(3)(4)	667,793			50,803			7.61	%	613,185			42,481			6.93	%	583,020			37,364			6.41	%
FHLB stock	7,351			427			5.81	%	6,967			349			5.01	%	6,671			275			4.12	%
Interest bearing deposits	6,261			290			4.63	%	11,339			306			2.70	%	16,635			189			1.14	%
Total interest earning assets	739,215			53,987			7.30	%	700,849			45,431			6.48	%	648,703			39,165			6.04	%
Less: Allowance for loan losses	(7,456		)						(6,794		)						(5,890		)
Non-interest earning assets	57,227								57,632								55,760
Total assets	$	788,986							$	751,687							$	698,573
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest bearing liabilities:
Savings accounts	$	91,418		$	2,542		2.78	%	$	90,941		$	1,678		1.85	%	$	84,089		$	783		0.93	%
NOW and money market accounts	129,063			2,061			1.60	%	147,731			2,093			1.42	%	135,265			1,156			0.85	%
Certificates of deposit and other time deposits	352,364			14,085			4.00	%	312,807			9,428			3.01	%	291,486			8,539			2.93	%
Short-term borrowings	35,826			1,904			5.31	%	3,655			148			4.05	%	3,424			47			1.37	%
FHLB advances	54,503			2,621			4.81	%	78,629			3,803			4.84	%	78,543			3,738			4.76	%
Subordinated debentures	10,000			895			8.95	%	10,000			712			7.12	%	10,000			529			5.29	%
Total interest bearing liabilities	673,174			24,108			3.58	%	643,763			17,862			2.77	%	602,807			14,792			2.45	%
Non-interest bearing liabilities:
Non-interest bearing deposits	42,289								41,505								34,925
Other liabilities	4,768								3,780								3,014
Total liabilities	720,231								689,048								640,746
Stockholders’ equity	68,755								62,639								57,827
Total liabilities and stockholders’ equity	$	788,986							$	751,687							$	698,573
Net interest income				$	29,879							$	27,569							$	24,373
Net interest spread							3.72	%							3.71	%							3.58	%
Net interest margin							4.04	%							3.93	%							3.76	%
Ratio of average interest earning assets to average interest bearing liabilities							109.81	%							108.87	%							107.61	%

(1) Taxable equivalent yields are calculated assuming a 34% federal income tax rate.

(2) Includes loan fees, immaterial in amount, in both interest income and the calculation of yield on loans.

(3) Calculations include non-accruing loans in the average loan amounts outstanding.

(4) Includes loans held for sale.

RATE/VOLUME ANALYSIS

The table below provides information regarding changes in interest income and interest expense for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in rate (changes in rate multiplied by old volume); (2) changes in volume (change in volume multiplied by old rate); and (3) changes in rate-volume (change in rate multiplied by change in volume). Changes in rate-volume are proportionately allocated between rate and volume variance.

	Year Ended									Year Ended
	December 31,									December 31,
	2006 vs. 2005									2005 vs. 2004
	Increase (decrease)									Increase (decrease)
	Due to change in									Due to change in
							Net									Net
	Rate			Volume			Change			Rate			Volume			Change
	(Dollars in thousands)
Interest income:
U.S. Treasury and agencies	$	194		$	(622	)	$	(428	)	$	6		$	585		$	591
Mortgage-backed securities	26			89			115			29			135			164
Equity securities	(16		)	(4		)	(20		)	19			(50		)	(31		)
State and political subdivision
securities	5			268			273			(1		)	120			119
Corporate bonds	232			—			232			115			—			115
Loans	4,362			3,960			8,322			3,123			1,994			5,117
FHLB stock	58			20			78			61			13			74
Interest bearing deposits	159			(175		)	(16		)	193			(76		)	117
Total interest earning assets	5,020			3,536			8,556			3,545			2,721			6,266
Interest expense:
Savings accounts	855			9			864			826			69			895
NOW and money market accounts	249			(281		)	(32		)	822			115			937
Certificates of deposit and other time deposits	3,356			1,301			4,657			251			638			889
Short-term borrowings	1,756			—			1,756			101			—			101
FHLB advances	(22		)	(1,160		)	(1,182		)	61			4			65
Subordinated debentures	183			—			183			183			—			183
Total interest bearing liabilities	6,377			(131		)	6,246			2,244			826			3,070
Net change in net interest income	$	(1,357	)	$	3,667		$	2,310		$	1,301		$	1,895		$	3,196

Non-Interest Income and Non-Interest Expense

The following tables provide a comparison of the components of non-interest income and expenses for the years ended December 31, 2006, 2005 and 2004. The tables show the dollar and percentage change from 2005 to 2006 and from 2004 to 2005. Below each table is a discussion of significant changes and trends.

							2006/2005						2005/2004
	2006		2005		2004		Change				%		Change				%
	(Dollars in thousands)
Non-interest income
Customer sevice fees on deposit accounts	$	5,460	$	5,167	$	4,913		$	293		5.7	%		$	254		5.2	%
Gain on sale of mortgage loans	783		868		862			(85		)	-9.8	%		6			0.7	%
Gain on sale of investments	—		381		202			(381		)	-100.0	%		179			88.6	%
Gain on sale of real estate held for development	—		143		526			(143		)	-100.0	%		(383		)	-72.8	%
Brokerage commissions	346		313		404			33			10.5	%		(91		)	-22.5	%
Other income	1,150		1,195		1,197			(45		)	-3.8	%		(2		)	-0.2	%
	$	7,739	$	8,067	$	8,104		$	(328	)	-4.1	%		$	(37	)	-0.5	%

Growth in customer service fees on deposit accounts, our largest component of non-interest income, is primarily due to growth in customer deposits, overdraft fee income on retail checking accounts and the sale of fee based products for 2006, 2005 and 2004. We continue to increase our customer base through cross-selling opportunities and marketing initiatives and promotions. In addition, we continue to emphasize growing our checking account base to better enhance our profitability and franchise value.

We originate qualified VA, KHC, RHC and conventional secondary market loans and sell them into the secondary market with servicing rights released. Gain on sale of mortgage loans decreased for 2006 compared to 2005 due to a decrease in the volume of loans closed. For 2005, gain on sale of mortgage loans remained steady compared to 2004.

We invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, mutual funds, stocks and others. During 2006 we did not record any gains on the sale of investments compared to $381,000 and $202,000 in recorded gains for the 2005 and 2004 periods. Gains on investment securities are infrequent in nature and are not a consistent recurring source of income.

Through our subsidiary, First Federal Office Park, we hold commercial lots adjacent to our home office on Ring Road in Elizabethtown, that are available for sale. During 2005 we recorded $143,000 in gains from a lot sale compared to $526,000 in gains from the sale of three properties held for development during 2004. Currently, two of the original nine lots held for sale remain unsold.

Other income decreased for 2006 due to decreases in trust income, write downs on real estate acquired through foreclosure and refunded loan fees. During the fourth quarter of 2004 we made the decision to outsource our trust operations and implemented this plan during 2005. However, we still held some of these trust assets until June 2006. As of December 2006, all trust operations have been outsourced. Included in other income for the year ended December 31, 2006 is income from trust operations of $63,000 as compared to $93,000 for 2005. We also recorded a $73,000 gain recorded on the sale of our credit card portfolio during the third quarter of 2006, in which a total of $610,000 in retail credit card balances were sold at a 12% premium.

							2006/2005					2005/2004
	2006		2005		2004		Change			%		Change				%
	(Dollars in thousands)
Non-interest expenses
Employee compensation and benefits	$	11,903	$	11,126	$	10,295		$	777	7.0	%		$	831		8.1	%
Office occupancy expense and equipment	2,106		2,065		1,833			41		2.0	%		232			12.7	%
Marketing and advertising	859		778		726			81		10.4	%		52			7.2	%
Outside services and data processing	2,567		2,393		2,134			174		7.3	%		259			12.1	%
Bank franchise tax	871		788		822			83		10.5	%		(34		)	-4.1	%
Other expense	3,646		3,609		3,464			37		1.0	%		145			4.2	%
	$	21,952	$	20,759	$	19,274		$	1,193	5.7	%		$	1,485		7.7	%

Employee compensation and benefits is the largest component of non-interest expense. Compensation expense increased for 2006 due to an increase in staff needed for our continued growth and expansion as well as annual raises. We have increased our staff in each of the last three years as we expand the products and services we offer our retail and commercial customers and increase the number and size of our branch offices. Employee compensation and benefits expense for the 2006 period also increased by $129,000, due to a change in accounting rules in which compensation expense related to stock options is recorded. We expect a continued increase in employee compensation and benefits expense in line with recent years, as we progress with our retail expansion and market protection efforts.

Office occupancy expense and equipment, marketing and advertising, and outside services and data processing increased due to additional operating expenses related to our expansion efforts during 2006, 2005 and 2004. The two full service branch openings in 2004 contributed to higher operating costs including additional postage for promotions and direct mailings for marketing, along with increased communications and supplies expense.

We anticipate our non-interest expense to continue to increase in 2007 as our retail expansion and market share efforts continue. During the second quarter of 2006 we opened a new full service-banking center in Elizabethtown and began construction on a third facility in Jefferson County, which we expect to open in early 2007. We are also considering other possible locations within our core market area to maintain or grow our 21% market share. Our efficiency ratio was 59% for 2006 compared to 58% for the 2005 period.

ANALYSIS OF FINANCIAL CONDITION

Total assets at December 31, 2006 increased to $822.8 million compared to $766.5 million at December 31, 2005, an increase of $56.3 million. The increase was primarily driven by an increase in loans of $62.3 million. The growth in loans was funded with deposits, which increased $49.9 million for the period, and $9.1 million in proceeds from investment securities.

Loans

Net loans increased $62.3 million or 10% to $698 million at December 31, 2006 compared to $635.7 million at December 31, 2005. Our commercial, commercial real estate and real estate construction portfolios increased $71.8 million, an 18% increase in these loans to $475 million at December 31, 2006. For the 2006 period, these loans comprised 67% of the total loan portfolio compared to 63% of the loan portfolio at December 31, 2005. Offsetting this growth was a $5.4 million, or 4% decrease in the residential mortgage loan portfolio to $137.3 million at December 31, 2006, compared to $142.7 million at December 31, 2005. Consumer and home equity loans also decreased for the 2006 period by $3.4 million to $62.8 million at December 31, 2006. For 2007, the growth in commercial, commercial real estate and real estate construction loans is expected to continue in line with recent years as we continue to emphasize commercial lending.

Loan Portfolio Composition. The following table presents a summary of the loan portfolio, net of deferred loan fees, by type. There are no foreign loans in our portfolio and other than the categories noted; there is no concentration of loans in any industry exceeding 10% of total loans.

	December 31,
	2006				2005				2004				2003				2002
	Amount		%		Amount		%		Amount		%		Amount		%		Amount		%
	(Dollars in thousands)
Type of Loan:
Real Estate:
Residential	$	137,155	19.44	%	$	142,358	22.14	%	$	158,966	26.23	%	$	190,088	34.21	%	$	262,990	49.34	%
Construction	23,953		3.39		13,579		2.11		10,850		1.79		9,952		1.79		12,857		2.41
Commercial	410,146		58.12		353,637		54.99		302,567		49.94		230,964		41.56		133,328		25.01
Consumer and home equity	62,805		8.90		66,208		10.29		70,141		11.58		64,759		11.65		67,398		12.64
Indirect consumer	30,857		4.37		31,577		4.91		30,798		5.08		28,279		5.09		20,594		3.86
Commercial, other	40,121		5.68		35,161		5.47		31,376		5.18		30,658		5.52		32,268		6.05
Loans held for sale	673		0.10		597		0.09		1,219		0.20		1,021		0.18		3,676		0.69
Total loans	$	705,710	100.00	%	$	643,117	100.00	%	$	605,917	100.00	%	$	555,721	100.00	%	$	533,111	100.00	%

Loan Maturity Schedule. The following table provides information at December 31, 2006, regarding the dollar amount of loans, net of deferred loan fees, maturing in the loan portfolio based on their contractual terms to maturity.

				Due after
	Due during			1 through			Due after 5
	the year ended			5 years after			years after
	December 31,			December 31,			December 31,			Total
	2007			2006			2006			Loans
	(Dollars in thousands)
Residential mortgage		$	8,002		$	23,555		$	105,598	$	137,155
Real estate construction		23,953			—			—		23,953
Real estate commercial		127,537			250,764			31,845		410,146
Consumer, home equity and indirect consumer		11,374			45,879			36,409		93,662
Commercial, other		16,942			21,499			1,680		40,121
Loans held for sale		673			—			—		673
Total		$	188,481		$	341,697		$	175,532	$	705,710

The following table breaks down loans maturing after one year, by fixed and adjustable rates.

				Floating or
	Fixed Rates			Adjustable Rates			Total
	(Dollars in thousands)
Residential mortgage		$	73,290		$	55,863	$	129,153
Real estate commercial		122,026			160,583		282,609
Consumer, home equity and indirect consumer		50,415			31,873		82,288
Commercial, other		17,035			6,144		23,179
Total		$	262,766		$	254,463	$	517,229

Allowance and Provision for Loan Losses

Our financial performance depends on the quality of the loans we originate and management’s ability to assess the degree of risk in existing loans when it determines the allowance for loan losses. An increase in loan charge-offs or non-performing loans or an inadequate allowance for loan losses could reduce net interest income, net income and capital and limit the range of products and services we can offer.

The Allowance for Loan Loss Review Committee evaluates the allowance for loan losses quarterly to maintain a level sufficient to absorb probable credit losses existing in the loan portfolio. Periodic provisions to the allowance are made as needed. The allowance is determined based on the application of loss estimates to graded loans by categories. The amount of the provision for loan losses necessary to maintain an adequate allowance is also based upon an analysis of such factors as changes in lending policies and procedures; underwriting standards; collection; charge-off and recovery history; changes in national and local economic business conditions and developments; changes in the characteristics of the portfolio; ability and depth of lending management and staff; changes in the trend of the volume and severity of past due, non-accrual and classified loans; troubled debt restructuring and other loan modifications; and results of regulatory examinations.

The following table provides an analysis of loan loss experience for the periods indicated.

													Six Months Ended				Year Ended
	Year Ended December 31,												December 31,				June 30,
	2006			2005			2004			2003			2002				2002
	(Dollars in thousands)
Balance at beginning of period	$	7,377		$	6,489		$	5,568		$	4,576			$	3,735			$	2,906
Loans charged-off:
Real estate mortgage	3			15			41			60				5				25
Consumer	446			584			702			721				419				635
Commercial	165			67			206			76				—				256
Total charge-offs	614			666			949			857				424				916
Recoveries:
Real estate mortgage	7			4			—			—				—				6
Consumer	287			290			214			190				74				97
Commercial	87			2			—			3				30				38
Total recoveries	381			296			214			193				104				141
Net loans charged-off	233			370			735			664				320				775
Provision for loan losses	540			1,258			1,656			1,656				1,161				1,604
Balance at end of period	$	7,684		$	7,377		$	6,489		$	5,568			$	4,576			$	3,735
Allowance for loan losses to total loans (excluding loans held for sale)	1.09		%	1.15		%	1.07		%	1.00		%		0.86		%		0.71		%
Net charge-offs to average loans outstanding	0.03		%	0.06		%	0.13		%	0.12		%		0.12		%		0.15		%
Allowance for loan losses to total non-performing loans	159		%	118		%	124		%	105		%		100		%		100		%

The provision for loan losses decreased $718,000 to $540,000 for 2006, compared to 2005. We recorded a smaller provision for 2006 due to an improvement in our security and position of certain classified loans during the period, resulting in a reduction in the allowance allocated to the loans. In addition, our provision for loan loss was higher in 2005, resulting from two classified loans downgraded to substandard. The allowance for loan losses increased $307,000 to $7.7 million from December 31, 2005 to December 31, 2006. The increase in the allowance in 2006 reflected a $62.5 million increase in net loans for the year, as well as a $1.6 million increase in classified loans.

The provision for loan losses decreased $398,000, or 24% to $1.3 million for 2005, compared to 2004. The decrease in the provision reflected a decrease in net charge offs of $365,000 to $370,000 during 2005 compared to $735,000 the prior year, due to lower commercial and indirect consumer loan charge-offs. The total allowance for loan losses increased $888,000 to $7.4 million from December 31, 2004 to December 31, 2005. The increase in the allowance reflected a $37.8 million increase in net loans during 2005 compared to 2004, and a $2.8 million increase in classified loans for 2005.

The following table depicts management’s allocation of the allowance for loan losses by loan type. Allowance and allocation is based on management’s current evaluation of risk in each category, economic conditions, past loss experience, loan volume, past due history and other factors. Since these factors and management’s assumptions are subject to change, the allocation is not a prediction of future portfolio performance.

December 31,

2006

2005

2004

2003

2002

Amount of

Allowance

Percent of

Total loans

Amount of

Allowance

Percent of

Total loans

Amount of

Allowance

Percent of

Total loans

Amount of

Allowance

Percent of

Total loans

Amount of

Allowance

Percent of

Total loans

(Dollars in thousands)

Residential mortgage	$	340	20	%	$	373	22	%	$	413	26	%	$	456	34	%	$	608	49	%
Consumer	1,298		13		1,372		15		1,345		17		1,235		17		1,096		17
Commercial	6,046		67		5,632		63		4,731		57		3,877		49		2,872		34
Total	$	7,684	100	%	$	7,377	100	%	$	6,489	100	%	$	5,568	100	%	$	4,576	100	%

Federal regulations require banks to classify their own assets on a regular basis. The regulations provide for three categories of classified loans—substandard, doubtful and loss. A bank must establish general allowances for loan losses for any assets classified as substandard or doubtful. If an asset or portion thereof is classified as loss, the bank must either establish specified allowances for loan losses in the amount of 100% of the portion of the asset classified loss, or charge off the amount of the loss.

The following table provides information with respect to classified loans for the periods indicated:

	December 31,
	2006		2005
	(Dollars in thousands)
Classified Loans
Substandard	$	11,520	$	9,826
Doubtful	858		933
Loss	31		21
Total Classified	$	12,409	$	10,780

The $1.7 million increase in substandard assets for 2006 was primarily the result of the downgrading of loans with two borrowers in the amount of a $2.9 million and $1.1 million, respectively. Offsetting this increase were pay offs of two classified loans having balances of $763,000 and $239,000. We remain well secured and adequately collateralized with these credits.

Although we may allocate a portion of the allowance to specific loans or loan categories, the entire allowance is available for active charge-offs. We develop our allowance estimates based on actual loss experience adjusted for current economic conditions. Allowance estimates represent a prudent measurement of the risk in the loan portfolio, which we apply to individual loans based on loan type.

Non-Performing Assets

Non-performing assets consist of certain restructured loans for which interest rate or other terms have been renegotiated, loans on which interest is no longer accrued, real estate acquired through foreclosure and repossessed assets. We do not have any loans greater than 90 days past due still on accrual. Loans, including impaired loans, are placed on non-accrual status when they become past due 90 days or more as to principal or interest, unless they are adequately secured and in the process of collection. Loans are considered impaired when we no longer anticipate full principal or interest payments in accordance with the contractual loan terms. We carry impaired loans at the present value of expected future cash flows discounted at the loan’s effective interest rate or at the fair value of the collateral if the loan is secured by collateral.

We review our loans on a regular basis and implement normal collection procedures when a borrower fails to make a required payment on a loan. If the delinquency on a mortgage loan exceeds 90 days and is not cured through normal collection procedures or an acceptable arrangement is not worked out with the borrower, we institute measures to remedy the default, including commencing a foreclosure action. We generally charge off consumer loans when management deems a loan uncollectible and any available collateral has been liquidated. We handle commercial business and real estate loan delinquencies on an individual basis with the advice of legal counsel.

We recognize interest income on loans on the accrual basis except for those loans in a non-accrual of income status. We discontinue accruing interest on impaired loans when management believes, after consideration of economic and business conditions and collection efforts that the borrowers’ financial condition is such that collection of interest is doubtful, typically after the loan becomes 90 days delinquent. When we discontinue interest accrual, we reverse existing accrued interest and subsequently recognize interest income only to the extent we receive cash payments.

We classify real estate acquired as a result of foreclosure or by deed in lieu of foreclosure as real estate owned until such time as it is sold. We classify new and used automobile, motorcycle and all terrain vehicles acquired as a result of foreclosure as repossessed assets until they are sold. When such property is acquired we record it at the lower of the unpaid principal balance of the related loan or its fair market value. We charge any write-down of the property at the time of acquisition to the allowance for loan losses. Subsequent gains and losses are included in non-interest income and non-interest expense.

The following table provides information with respect to non-performing assets as of the periods indicated.

		December 31,
		2006			2005			2004			2003			2002
		(Dollar in thousands)
Restructured		$	2,470		$	3,104		$	3,218		$	3,037		$	3,325
Past due 90 days still on accrual		—			—			—			—			—
Loans on non-accrual status		2,368			3,128			2,022			2,281			1,259
Total non-performing loans		4,838			6,232			5,240			5,318			4,584
Real estate acquired through foreclosure		918			1,022			681			387			510
Other repossessed assets		82			119			40			62			119
Total non-performing assets		$	5,838		$	7,373		$	5,961		$	5,767		$	5,213
Interest income that would have been earned on non-performing loans		$	368		$	432		$	336		$	374		$	177
Interest income recognized on non-performing loans		227			219			197			227			126
Ratios:	Non-performing loans to total loans (excluding loans held for sale)	0.69		%	0.97		%	0.87		%	0.96		%	0.87		%
	Non-performing assets to total loans (excluding loans held for sale)	0.83		%	1.15		%	0.99		%	1.04		%	0.98		%

Non-performing assets for the 2006 period include $2.5 million in restructured commercial, residential mortgage and consumer loans. The restructured loans primarily consist of two credit relationships with balances of $2.1 million and $204,000. The terms of these loans have been renegotiated to reduce the rate of interest and extend the term, thus reducing the amount of cash flow required from the borrower to service the loans. The borrowers are currently meeting the terms of the restructured loans.

Non-performing assets for 2005 includes $3.1 million in restructured commercial and residential mortgage loans. The restructured loans primarily consist of two commercial relationships with balances of $2.2 million and $210,000 and a $452,000 residential mortgage relationship.

Investment Securities

Interest on securities provides us our largest source of interest income after interest on loans, constituting 5.6% of the total interest income for the year ended December 31, 2006. The securities portfolio serves as a source of liquidity and earnings and contributes to the management of interest rate risk. We have the authority to invest in various types of liquid assets, including short-term United States Treasury obligations and securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, certificates of deposit at insured savings and loans and banks, bankers’ acceptances, and federal funds. We may also invest a portion of our assets in certain commercial paper and corporate debt securities. We are also authorized to invest in mutual funds and stocks whose assets conform to the investments that we are authorized to make directly. The available-for-sale and held-to-maturity investment portfolios decreased by $9.1 million during the 2006 period as securities were called for redemption in accordance with their terms due to increasing rates. During the year we made purchases of investments in state and municipal obligations and corporate bonds. The corporate bonds re-price quarterly with three-month LIBOR. The state and municipal obligations have an average life of 10 years. We purchased these securities to enhance earnings and manage interest rate risk by placing assets with longer terms on the balance sheet. See Note 2 of the Notes to Consolidated Financial Statements for further information concerning the investment portfolio.

We review unrealized losses at least on a quarterly basis to determine whether the losses are other than temporary and more frequently when economic or market concerns warrant such evaluation. We consider the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and our intent and ability to retain the investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer’s financial condition, we may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition. The unrealized losses on our investments in U.S. Treasury and agencies, mortgage-backed securities and obligations of state and political subdivisions are due to interest rate increases. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because we have the ability and intent to hold these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2006.

The following table provides the carrying value of our securities portfolio at the dates indicated.

	December 31,
	2006		2005		2004
	(Dollars in thousands)
Securities available-for-sale:
U.S. Treasury and agencies	$	3,484	$	6,437	$	15,929
Mortgage-backed	9,244		11,302		1,879
Equity	2,146		1,991		3,079
State and municipal	10,029		5,558		1,041
Corporate	3,320		3,036		—
Total	$	28,223	$	28,324	$	21,928
Securities held-to-maturity:
U.S. Treasury and agencies	$	18,097	$	26,095	$	26,095
Mortgage-backed	4,127		5,136		6,820
Corporate	2,000		2,000		2,000
Total	$	24,224	$	33,231	$	34,915

The following table provides the scheduled maturities, amortized cost, fair value and weighted average yields for our securities at December 31, 2006.

						Weighted
	Amortized			Fair		Average
	Cost			Value		Yield*
	(Dollars in thousands)
Securities available-for-sale:
Due in one year or less		$	1,375	$	1,374		4.38	%
Due after one year through five years		3,955		3,922			4.74
Due after five years through ten years		3,459		3,387			4.21
Due after ten years		17,752		17,394			4.61
Equity		1,553		2,146			3.70
Total		$	28,094	$	28,223		4.52

						Weighted
	Amortized			Fair		Average
	Cost			Value		Yield*
	(Dollars in thousands)
Securities held-to-maturity:
Due in one year or less		$	4,000	$	3,948		3.16	%
Due after one year through five years		17,984		17,611			3.74
Due after five years through ten years		28		29			7.31
Due after ten years		2,212		2,229			7.08
Total		$	24,224	$	23,817		3.95

* The weighted average yields are calculated on amortized cost on a non tax-equivalent basis.

Deposits

We rely primarily on customer service and long-standing relationships with customers to attract and retain deposits. Market interest rates and rates on deposit products offered by competing financial institutions can significantly affect our ability to attract and retain deposits. We attract both short-term and long-term deposits from the general public by offering a wide range of deposit accounts and interest rates. In recent years market conditions have caused us to rely increasingly on short-term certificate accounts and other deposit alternatives that are more responsive to market interest rates. We use forecasts based on interest rate risk simulations to assist management in monitoring our use of certificates of deposit and other deposit products as funding sources and the impact of the use of those products on interest income and net interest margin in various rate environments.

In conjunction with our initiatives to expand and enhance our retail branch network, we emphasize growing our customer checking account base to better enhance profitability and franchise value. Retail and commercial deposits increased $35.1 million and we added $35.0 million in brokered certificates of deposit for the year. These increases were offset by a $20.2 million decrease in public fund deposits, resulting in an increase in total deposits of $49.9 million for the period. The increase in retail deposits was primarily in certificate of deposit balances due to a promotion and customers moving from money market and savings products into more attractive certificate of deposit products.

To evaluate our funding needs in light of deposit trends resulting from these changing conditions, management and Board committees evaluate simulated performance reports that forecast changes in margins. We continue to offer attractive certificate rates for various terms to allow us to retain deposit customers and reduce interest rate risk during the current rate environment, while protecting the margin.

We offer a broad selection of deposit instruments, including non-interest bearing checking, statement and passbook savings accounts, health savings accounts, NOW accounts, money market accounts and fixed and variable rate certificates with varying maturities. We also offer tax-deferred individual retirement accounts. The flow of deposits is influenced significantly by general economic conditions, changes in interest rates and competition. As of December 31, 2006, approximately 39% of our deposits consisted of various savings and demand deposit accounts from which customers can withdraw funds at any time without penalty. Management periodically adjusts interest rates paid on our deposit products, maturity terms, service fees and withdrawal penalties.

We also offer certificates of deposit with a variety of terms, interest rates and minimum deposit requirements. The variety of deposit accounts allows us to compete more effectively for funds and to respond with more flexibility to the flow of funds away from depository institutions into direct investment vehicles such as government and corporate securities. However, market conditions continue to significantly affect our ability to attract and maintain deposits and our cost of funds.

The following table breaks down our deposits.

	December 31,
	2006		2005
	(Dollars in thousands)
Non-interest bearing	$	40,349	$	39,145
NOW demand	73,552		76,848
Savings	84,994		99,879
Money market	53,917		66,175
Certificates of deposit	388,225		309,059
Total	$	641,037	$	591,106

As of December 31, 2006, certificates of deposits in amounts of $100,000 or more totaled $122.8 million, most of which were held by persons residing within our service areas. An additional $35.5 million of certificates of deposits in amounts of $100,000 or more were obtained from deposit brokers at December 31, 2006. Brokered deposits consist of certificates of deposit placed by deposit brokers for a fee and can be utilized to support our asset growth.

The following table shows at December 31, 2006 the amount of our certificates of deposit of $100,000 or more by time remaining until maturity.

	Certificates
Maturity Period	of Deposit
	(In Thousands)
Three months or less		$	25,465
Three through six months		22,172
Six through twelve months		66,261
Over twelve months		44,372
Total		$	158,270

Short-term Borrowings

We have the ability to obtain short-term borrowings, consisting of federal funds purchased and securities sold under agreements to repurchase at year end 2006 and 2005. We had short-term borrowings of $68.5 million for 2006 and $19.5 million for 2005 from the FHLB of Cincinnati. These borrowings averaged a rate of 5.31% for 2006 and 4.05% for 2005.

Advances from Federal Home Loan Bank

Deposits are the primary source of funds for our lending and investment activities and for our general business purposes. We can also use advances (borrowings) from the FHLB of Cincinnati to compensate for reductions in deposits or deposit inflows at less than projected levels. Advances from the FHLB are secured by our stock in the FHLB, certain securities, certain commercial real estate loans and substantially all of our first mortgage loans. At December 31, 2006 we had $28.2 million in advances outstanding from the FHLB and the capacity to increase our borrowings an additional $41.6 million.

The FHLB of Cincinnati functions as a central reserve bank providing credit for savings banks and other member financial institutions. As a member, we are required to own capital stock in the FHLB and are authorized to apply for advances on the security of such stock and certain of our home mortgages and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided that we meet certain creditworthiness standards. For further information, see Note 7 of the Notes to Consolidated Financial Statements in this Annual Report.

The following table provides information about our FHLB advances and short-term borrowings as of and for the periods ended.

	December 31,
	2006			2005			2004
	(Dollars in thousands)
Average balance outstanding	$	90,329		$	82,284		$	78,543
Maximum amount outstanding at any month-end during the period	121,836			97,875			78,974
Year end balance	96,724			97,875			78,904
Weighted average interest rate:
At end of year	5.00		%	4.76		%	4.87		%
During the year	5.01		%	4.80		%	4.76		%

LIQUIDITY

Liquidity risk arises from the possibility we may not be able to satisfy current or future financial commitments, or may become unduly reliant on alternative funding sources. The objective of liquidity risk management is to ensure that we can meet the cash flow requirements of depositors and borrowers, as well as our operating cash needs, at a reasonable cost, taking into account all on- and off-balance sheet funding demands. We maintain an investment and funds management policy, which identifies the primary sources of liquidity, establishes procedures for monitoring and measuring liquidity, and establishes minimum liquidity requirements in compliance with regulatory guidance. The Asset Liability Committee continually monitors our liquidity position.

Our sources of funds include the sale of securities in the available-for-sale portion of the investment portfolio, principal pay-downs on loans and mortgage-backed securities, proceeds realized from loans held for sale, brokered deposits and other wholesale funding. We also secured federal funds borrowing lines from two of our correspondent banks of $15 million each. Our banking centers also provide access to retail deposit markets. If large certificate depositors shift to our competitors or other markets in response to interest rate changes, we have the ability to replenish those deposits through alternative funding sources. Traditionally, we have also borrowed from the FHLB to supplement our funding requirements. At December 31, 2006, we had an unused approved line of credit in the amount of $96.5 million and sufficient collateral available to borrow, approximately, an additional $41.6 million in advances from the FHLB. We believe our sources of liquidity are adequate to meet expected cash needs for the foreseeable future.

At the holding company level, the Corporation uses cash to pay dividends to stockholders, repurchase common stock, make selected investments and acquisitions, and service debt. The main sources of funding for the Corporation include dividends from the Bank, borrowings and access to the capital markets.

The primary source of funding for the Corporation has been dividends and returns of investment from the Bank. Kentucky banking laws limit the amount of dividends that may be paid to the Corporation by the Bank without prior approval of the KOFI. Under these laws, the amount of dividends that may be paid in any calendar year is limited to current year’s net income, as defined in the laws, combined with the retained net income of the preceding two years, less any dividends declared during those periods. At December 31, 2006, the Bank had approximately $12.3 million of retained earnings that could be used to pay dividends without prior regulatory approval. Because of these limitations, consolidated cash flows as presented in the consolidated statements of cash flows may not represent cash immediately available to the Corporation. During 2006, the Bank declared and paid dividends of $4.2 million to the Corporation.

CAPITAL

Stockholders’ equity increased by $7.4 million during 2006, primarily due to net income earned during the year. This increase was offset by cash dividends declared. Average stockholders’ equity to average assets ratio increased to 8.71% at December 31, 2006 from 8.33% at the end of 2005.

During 2006, we purchased 500 shares of our own common stock for $15,500. During the third quarter, our Board of Directors authorized the repurchase of 398,601 shares from time-to-time if market conditions are deemed favorable. The repurchase program will remain effective until the number of shares authorized is repurchased or until the program expires September 19, 2008. As of December 31, 2006, 398,101 shares could be repurchased under the current stock repurchase program.

Each of the federal bank regulatory agencies has established minimum leverage capital requirements for banks. Banks must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets ranging from 3% to 5%, subject to federal bank regulatory evaluation of an organization’s overall safety and soundness. We intend to maintain a capital position that meets or exceeds the “well capitalized” requirements established for banks by the FDIC. The following table shows the ratios of Tier 1 capital and total capital to risk-adjusted assets and the leverage ratios for the Corporation and the Bank as of December 31, 2006.

	Capital Adequacy Ratios as of
	December 31, 2006
	Regulatory				Well-Capitalized
Risk-Based Capital Ratios		Minimums				Minimums			The Bank			The Corporation
Tier 1 capital(1)			4.0	%			6.0	%		10.0	%		10.4	%
Total risk-based capital(2)			8.0	%			10.0	%		11.2	%		11.6	%
Tier 1 leverage ratio(3)			4.0	%			5.0	%		8.9	%		9.2	%

(1) Shareholders’ equity plus corporation-obligated mandatory redeemable capital securities, less unrealized gains (losses) on debt securities available for sale, net of deferred income taxes, less nonqualifying intangible assets; computed as a ratio of risk-weighted assets, as defined in the risk-based capital guidelines.

(2) Tier 1 capital plus qualifying loan loss allowance and subordinated debt; computed as a ratio of risk-weighted assets, as defined in the risk-based capital guidelines.

(3) Tier 1 capital computed as a percentage of fourth quarter average assets less nonqualifying intangibles.

OFF BALANCE SHEET ARRANGEMENTS

Our off balance sheet arrangements consist of commitments to make loans, unused borrower lines of credit, and stand by letters of credit, which are disclosed in Note 16 to the consolidated financial statements.

AGGREGATE CONTRACTUAL OBLIGATIONS

					Greater than			Greater than
			Less than		one year to			3 years to			More than
December 31, 2006	Total		one year		3 years			5 years			5 years
	(Dollars in thousands)
Aggregate Contractual Obligations:
Time deposits	$	388,225	$	269,033		$	102,039		$	16,683		$	470
FHLB borrowings	28,224		139			268			25,262			2,555
Short-term borrowings	68,500		68,500			—			—			—
Subordinated debentures	10,000		—			—			—			10,000
Lease commitments	1,792		330			632			601			229

FHLB borrowings represent the amounts that are due to the FHLB of Cincinnati. These amounts have fixed maturity dates. One of these borrowings, although fixed, is subject to conversion provisions at the option of the FHLB. The FHLB has the right to convert this advance to a variable rate or we can prepay the advance at no penalty. There is a substantial penalty if we prepay the advance before the FHLB exercises its right. We do not believe this advance will be converted in the near term.

The subordinated debentures, which mature March 26, 2032, are redeemable before the maturity date at our option on or after March 26, 2007 at their principal amount plus accrued interest. The subordinated debentures are also redeemable in whole or in part from time to time, upon the occurrence of specific events defined within the trust indenture. The interest rate on our subordinated debentures adjusts quarterly at three-month LIBOR plus 3.60%. Similar debt instruments are currently being issued with spreads to three-month LIBOR that are more favorable than our 3.60% spread. If this pricing continues through March 26, 2007, we will likely exercise our option to redeem our outstanding subordinated debentures on or after March 26, 2007. We have the option to defer distributions on the subordinated debentures from time to time for a period not to exceed 20 consecutive quarters.

Lease commitments represent the total future minimum lease payments under non-cancelable operating leases.

IMPACT OF INFLATION & CHANGING PRICES

The financial statements and related data presented herein have been prepared in accordance with U.S. generally accepted accounting principles, which require the measurement of financial position and operating results in historical dollars without considering changes in the relative purchasing power of money over time due to inflation.

We have an asset and liability structure that is essentially monetary in nature. As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation. Periods of high inflation are often accompanied by relatively higher interest rates, and periods of low inflation are accompanied by relatively lower interest rates. As market interest rates rise or fall in relation to the rates earned on our loans and investments, the value of these assets decreases or increases respectively.

Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Asset /Liability Management and Market Risk

To minimize the volatility of net interest income and exposure to economic loss that may result from fluctuating interest rates, we manage our exposure to adverse changes in interest rates through asset and liability management activities within guidelines established by our Asset Liability Committee (“ALCO”). The ALCO, which includes senior management representatives, has the responsibility for approving and ensuring compliance with asset/liability management polices. Interest rate risk is the exposure to adverse changes in the net interest income as a result of market fluctuations in interest rates. The ALCO, on an ongoing basis, monitors interest rate and liquidity risk in order to implement appropriate funding and balance sheet strategies. Management considers interest rate risk to be our most significant market risk.

We utilize an earnings simulation model to analyze net interest income sensitivity. We then evaluate potential changes in market interest rates and their subsequent effects on net interest income. The model projects the effect of instantaneous movements in interest rates of both 100 and 200 basis points. We also incorporate assumptions based on the historical behavior of our deposit rates and balances in relation to changes in interest rates into the model. These assumptions are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.

Our interest sensitivity profile was liability sensitive at December 31, 2006, compared to an asset sensitive position at December 31, 2005. Given a sustained 100 basis point decrease in rates, our base net interest income would increase by an estimated .55% at December 31, 2006 compared to a decrease of 2.03% at December 31, 2005. Given a 100 basis point increase in interest rates our base net interest income would decrease by an estimated .48% at December 31, 2006 compared to an increase of 1.92% at December 31, 2005.

Our interest sensitivity at any point in time will be affected by a number of factors. These factors include the mix of interest sensitive assets and liabilities, their relative pricing schedules, market interest rates, deposit growth, loan growth, decay rates and prepayment speed assumptions.

We have been restructuring our assets in the expectation that interest rates will be stable or decrease in the futures. As demonstrated by the December 31, 2006 and December 31, 2005 sensitivity tables, we transitioned from an asset sensitive to a liability sensitive position as compared to prior periods. This means that our earning assets, which consist of loans and investment securities, will change in price at a slower rate than our deposits and borrowings. Therefore, if short term interest rates increase, our net interest income will decrease. Likewise, if short term interest rates decrease, our net interest income will increase. Also changing from 2005 is the anticipated degree of change. As of December 31, 2006, an increase or decrease in interest rates of 200 basis points is projected to result in less than a 1% change in net interest income. Interest rate changes under our current balance sheet position will not have as large of impact on earnings as the balance sheet position at December 31, 2005, when a 200 basis point increase or decrease in interest rates was projected to result in over a 4.00% change in net interest income.

Our efforts to structure funding and future liquidity needs have decreased our asset sensitivity. From June 2004 until June 2006, the Federal Open Market Committee increased short-term interest rates. We believe the Federal Open Market Committee may decrease short term interest rates at some point in 2007. Our net interest margin and the level of net interest income would increase with a decrease in short term interest rates. We continually monitor the effects rate changes will have on our level of net interest income, and management works to structure the maturity and pricing of loans and deposits to mitigate large swings in net interest income. During 2006, we made efforts to increase the level of short-term deposits offering

more attractive rates on short-term certificates of deposits. Also, during the third quarter of 2006, we paid off a fixed rate FHLB advance that had converted to a variable rate advance. We replaced this borrowing with overnight short-term borrowings. In addition, the majority of the newly originated or renewed loans during 2005 and 2006 were fixed rates loans with the interest rate fixed from three to five years.

Our sensitivity to interest rate changes is presented based on data as of December 31, 2006 and December 31, 2005.

	December 31, 2006
	Decrease in Rates										Increase in Rates
	200				100						100				200
	Basis Points				Basis Points				Base		Basis Points				Basis Points
	(Dollars in thousands)
Projected interest income
Loans		$	58,262			$	59,517		$	60,592		$	61,623			$	62,759
Investments		2,342				2,482			2,535			2,625				2,653
Total interest income		60,604				61,999			63,127			64,248				65,412
Projected interest expense
Deposits		20,643				21,500			22,356			23,124				23,891
Borrowed funds		5,071				5,628			6,090			6,608				7,040
Total interest expense		25,714				27,128			28,446			29,732				30,931
Net interest income		$	34,890			$	34,871		$	34,681		$	34,516			$	34,481
Change from base		$	209			$	190					$	(165	)		$	(200	)
% Change from base		.60		%		.55		%				(.48		)%		(.58		)%

	December 31, 2005
	Decrease in Rates										Increase in Rates
	200				100						100				200
	Basis Points				Basis Points				Base		Basis Points				Basis Points
	(Dollars in thousands)
Projected interest income
Loans		$	48,350			$	49,818		$	51,077		$	52,281			$	53,539
Investments		2,703				2,846			2,948			2,995				3,062
Total interest income		51,053				52,664			54,025			55,276				56,601
Projected interest expense
Deposits		12,738				13,319			13,900			14,421				14,941
Borrowed funds		4,697				4,782			4,845			4,896				4,947
Total interest expense		17,435				18,101			18,745			19,317				19,888
Net interest income		$	33,618			$	34,563		$	35,280		$	35,959			$	36,713
Change from base		$	(1,662	)		$	(717	)				$	679			$	1,433
% Change from base		(4.71		)%		(2.03		)%				1.92		%		4.06		%

FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Income

	Year Ended December 31,
	2006		2005		2004
	(Dollars in thousands, except per share data)
Interest and Dividend Income:
Loans, including fees	$	50,803	$	42,481	$	37,364
Taxable securities	2,726		2,764		1,734
Tax exempt securities	303		123		45
Total interest income	53,832		45,368		39,143
Interest Expense:
Deposits	18,688		13,199		10,478
Short-term borrowings	1,904		148		47
Federal Home Loan Bank advances	2,621		3,803		3,738
Subordinated debentures	895		712		529
Total interest expense	24,108		17,862		14,792
Net interest income	29,724		27,506		24,351
Provision for loan losses	540		1,258		1,656
Net interest income after provision for loan losses	29,184		26,248		22,695
Non-interest Income:
Customer service fees on deposit accounts	5,460		5,167		4,913
Gain on sale of mortgage loans	783		868		862
Gain on sale of investments	—		381		202
Gain on sale of real estate held for development	—		143		526
Brokerage commissions	346		313		404
Other income	1,150		1,195		1,197
Total non-interest income	7,739		8,067		8,104
Non-interest Expense:
Employee compensation and benefits	11,903		11,126		10,295
Office occupancy expense and equipment	2,106		2,065		1,833
Marketing and advertising	859		778		726
Outside services and data processing	2,567		2,393		2,134
Bank franchise tax	871		788		822
Other expense	3,646		3,609		3,464
Total non-interest expense	21,952		20,759		19,274
Income before income taxes	14,971		13,556		11,525
Income taxes	4,634		4,412		3,735
Net Income	$	10,337	$	9,144	$	7,790
Shares applicable to basic income per share	4,383		4,398		4,428
Basic income per share	$	2.36	$	2.08	$	1.76
Shares applicable to diluted income per share	4,427		4,428		4,447
Diluted income per share	$	2.34	$	2.07	$	1.75

See notes to consolidated financial statements.

FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Changes in Stockholders’ Equity
Years Ending December 31, 2006, 2005 and 2004
(Dollars In Thousands, Except Per Share Amounts)

															Accumulated
															Other
								Additional							Comprehensive
	Common			Stock				Paid-in				Retained			Income, Net of
	Shares			Amount				Capital				Earnings			Tax				Total
Balance, January 1, 2004		3,705			$	3,705			$	9,726		$	42,092			$	798		$	56,321
Net income												7,790							7,790
Net change in unrealized gains (losses) on securities available-for-sale, net of tax																(42		)	(42		)
Cash dividends declared ($.61 per share)												(2,708		)					(2,708		)
Stock repurchased		(60	)		(60		)		(1,500		)	—				—			(1,560		)
Balance, December 31, 2004		3,645			3,645				8,226			47,174				756			59,801
Net income												9,144							9,144
Stock dividend-10%		363			363				8,834			(9,197		)					—
Exercise of stock options		5			5				80										85
Net change in unrealized gains (losses) on securities available-for-sale, net of tax																(699		)	(699		)
Cash dividends declared ($.64 per share)												(2,830		)					(2,830		)
Stock repurchased		(29	)		(29		)		(731		)	—				—			(760		)
Balance, December 31, 2005		3,984			3,984				16,409			44,291				57			64,741
Net income												10,337							10,337
Stock dividend-10%		398			398				10,835			(11,233		)					—
Stock issued for stock options exercised and employee benefit plans		3			3				61										64
Compensation expense for stock options									129										129
Net change in unrealized gains (losses) on securities available-for-sale, net of tax																28			28
Cash dividends declared ($.73 per share)												(3,185		)					(3,185		)
Stock repurchased		(1	)		(1		)		(15		)	—				—			(16		)
Balance, December 31, 2006		4,384			$	4,384			$	27,419		$	40,210			$	85		$	72,098

See notes to consolidated financial statements.

FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Cash Flows

	Year Ended December 31,
	2006			2005			2004
	(Dollars in thousands)
Operating Activities:
Net income	$	10,337		$	9,144		$	7,790
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses	540			1,258			1,656
Depreciation on premises and equipment	1,378			1,298			1,119
Federal Home Loan Bank stock dividends	(427		)	(349		)	(275		)
Net amortization (accretion) available-for-sale	17			8			16
Net amortization (accretion) held-to-maturity	31			55			71
Gain on sale of investments available-for-sale	—			(381		)	(202		)
Gain on sale of real estate held for development	—			(143		)	(526		)
Gain on sale of mortgage loans	(783		)	(868		)	(862		)
Origination of loans held for sale	(38,708		)	(45,446		)	(52,368		)
Proceeds on sale of loans held for sale	39,415			46,936			53,032
Deferred taxes	(20		)	234			401
Compensation expense for stock options	129			—			—
Changes in:
Cash surrender value of life insurance	(310		)	(284		)	(286		)
Interest receivable	(1,043		)	(564		)	(556		)
Other assets	499			(72		)	1,084
Interest payable	(116		)	(24		)	(3		)
Accounts payable and other liabilities	298			386			(150		)
Net cash from operating activities	11,237			11,188			9,941
Investing Activities:
Sales of securities available-for-sale	—			1,431			745
Purchases of securities available-for-sale	(6,641		)	(37,393		)	(18,640		)
Maturities of securities available-for-sale	6,767			28,880			—
Purchases of securities held-to-maturity	—			—			(24,100		)
Maturities of securities held-to-maturity	8,976			1,629			20,141
Net change in loans	(62,607		)	(38,612		)	(51,005		)
Net purchases of premises and equipment	(4,744		)	(2,963		)	(3,288		)
Sales of real estate held for development	—			195			509
Net cash from investing activities	(58,249		)	(46,833		)	(75,638		)
Financing Activities
Net change in deposits	49,931			4,720			57,224
Change in short-term borrowings	49,000			19,500			—
Advances from Federal Home Loan Bank	—			450			821
Repayments to Federal Home Loan Bank	(50,151		)	(979		)	(200		)
Issuance of common stock for options and employee benefit plans	64			85			—
Dividends paid	(3,185		)	(2,830		)	(2,708		)
Common stock repurchased	(16		)	(760		)	(1,560		)
Net cash from financing activities	45,643			20,186			53,577
(Decrease) in cash and cash equivalents	(1,369		)	(15,459		)	(12,120		)
Cash and cash equivalents, beginning of year	20,451			35,910			48,030
Cash and cash equivalents, end of year	$	19,082		$	20,451		$	35,910

See notes to consolidated financial statements.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The following is a description of the significant accounting policies First Financial Service Corporation follows in preparing and presenting its consolidated financial statements:

Principles of Consolidation and Business—The consolidated financial statements include the accounts of First Financial Service Corporation and its wholly owned subsidiary, First Federal Savings Bank. First Federal Savings Bank has two wholly owned subsidiaries, First Service Corporation of Elizabethtown and First Federal Office Park, LLC. Unless the text clearly suggests otherwise, references to “us,” “we,” or “our” include First Financial Service Corporation and its wholly-owned subsidiary. All significant intercompany transactions and balances have been eliminated in consolidation.

On January 8, 2003, the First Federal Savings Bank converted from a federal savings bank, regulated by the Office of Thrift Supervision (OTS), to a commercial bank chartered under Kentucky banking laws regulated by the Federal Deposit Insurance Corporation (FDIC) and the Kentucky Office of Financial Institutions (KOFI). At the same time, the First Financial Service Corporation became a bank holding company regulated by the Federal Reserve and changed its fiscal year from June 30 to December 31.

Our business consists primarily of attracting deposits from the general public and origination of mortgage loans on commercial property, single-family residences and multi-family housing. We also make home improvement loans, consumer loans and commercial business loans. Our primary lending area is a region within North Central Kentucky. The economy within this region is diversified with a variety of medical service, manufacturing, and agricultural industries, and Fort Knox, a military installation.

The principal sources of funds for our lending and investment activities are deposits, repayment of loans, Federal Home Loan Bank advances and other borrowings. Our principal source of income is interest on loans. In addition, other income is derived from loan origination fees, service charges, returns on investment securities, gain on sale of mortgage loans, and brokerage and insurance commissions.

Our subsidiary First Service Corporation is a licensed broker providing investment services and offering tax-deferred annuities, government securities and stocks and bonds to our customers. First Federal Office Park, LLC, another subsidiary, holds commercial lots adjacent to our home office on Ring Road in Elizabethtown, which are available for sale.

Estimates and Assumptions—The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of the amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. The allowance for loan losses and the fair value of financial instruments are particularly subject to change.

Cash Flows—For purposes of the statement of cash flows, we consider all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. Cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold and certain interest bearing deposits. Net cash flows are reported for interest-bearing deposits, loans, short-term borrowings and deposits.

Securities—We classify investments into held-to-maturity and available-for-sale. Debt securities in which management has a positive intent and ability to hold are classified as held-to-maturity and are carried at cost adjusted for the amortization of premiums and discounts using the interest method over the terms of the securities. Debt and equity securities, which do not fall into this category, are classified as

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES—(Continued)

available-for-sale. Unrealized holding gains and losses, net of tax, on available-for-sale securities are reported as a component of other comprehensive income.

Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments, except for mortgage backed securities where prepayments are anticipated. Gains and losses on sales are recorded on the trade date and determined using the specific identification method.

Declines in the fair value of securities below their cost that are other than temporary are reflected as realized losses. In estimating other-than-temporary losses, management considers: (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, and (3) our ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value.

Loans—Loans are stated at unpaid principal balances, less undistributed construction loans, and net deferred loan origination fees. We defer loan origination fees and discounts net of certain direct origination costs. These net deferred fees are amortized using the level yield method on a loan-by-loan basis over the lives of the underlying loans.

Interest income on loans is accrued on the unpaid principal balance except for those loans in nonaccrual status. The accrual of interest is discontinued when a loan becomes 90 or more days delinquent. When interest accrual is discontinued, interest income is subsequently recognized only to the extent cash payments are received. Interest accruals resume when the loan becomes less than 90 days delinquent.

Allowance for Loan Losses—The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when we believe the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Our periodic evaluation of the allowance is based on our past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and current economic conditions. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off.

Loans are considered impaired when, based on current information and events, it is probable that full principal or interest payments are not anticipated in accordance with the contractual loan terms. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Impaired loans are carried at the present value of expected future cash flows discounted at the loan’s effective interest rate or at the fair value of the collateral if the loan is collateral dependent. Commercial and commercial real estate loans are individually evaluated for impairment. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment and are not separately identified for impairment disclosures. A portion of the allowance for

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES—(Continued)

loan losses is allocated to impaired loans if the value of such loans is less than the unpaid balance. If these allocations cause the allowance for loan losses to require an increase, such increase is reported in the provision for loan losses.

Mortgage Banking Activities—Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or market value. To deliver closed loans to the secondary market and to control its interest rate risk prior to sale, we enter into “best efforts” agreements to sell loans. The aggregate market value of mortgage loans held for sale considers the price of the sales contracts. The loans are sold with servicing released.

Loan commitments related to the origination of mortgage loans held for sale are accounted for as derivative instruments. Our commitments are for fixed rate mortgage loans, generally lasting 60 to 90 days and are at market rates when initiated. Considered derivatives, we had commitments to originate $1.6 million and $1.2 million in loans at December 31, 2006 and 2005, which we intend to sell after the loans are closed.

The fair value was not material. Substantially all of the gain on sale generated from mortgage banking activities continues to be recorded when closed loans are delivered into the sales contracts.

Federal Home Loan Bank Stock—The Bank is a member of the FHLB system. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. Investment in stock of Federal Home Loan Bank is carried at cost, and periodically evaluated for impairment. Both cash and stock dividends are reported as income.

Cash Surrender Value of Life Insurance—We have purchased life insurance policies on certain key executives. The life insurance is recorded at its cash surrender value, or the amount that can be realized.

Premises and Equipment—Land is carried cost. Premises and equipment are stated at cost less accumulated depreciation. Buildings and related components are depreciated using the straight-line method with useful lives ranging from 5 to 40 years. Furniture, fixtures and equipment are depreciated using the straight-line method with useful lives ranging from 3 to 15 years.

Real Estate Owned—Real estate properties acquired through foreclosure and in settlement of loans are stated at lower of cost or fair value less estimated selling costs at the date of foreclosure. The excess of cost over fair value less the estimated costs to sell at the time of foreclosure is charged to the allowance for loan losses. Costs relating to development and improvement of property are capitalized, whereas costs relating to holding property are not capitalized and are charged against operations in the current period.

Real Estate Held for Development—Real estate properties held for development and sale are carried at the lower of cost, including cost of development and improvement subsequent to acquisition, or fair value less estimated selling costs. The portion of interest costs relating to the development of real estate is capitalized.

Other Repossessed Assets—Consumer assets acquired through repossession and in settlement of loans, typically automobiles, are carried at lower of cost or fair value at the date of repossession. The excess cost over fair value at time of repossession is charged to the allowance for loan losses.

Goodwill and Other Intangible Assets—Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES—(Continued)

identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment will be recognized in the period identified.

Stock Dividends—We declared a 10% stock dividend on August 15, 2006 to our shareholders of record as of August 29, 2006, payable on September 14, 2006. In addition, we declared another 10% stock dividend on September 20, 2005 to our shareholders of record as of October 7, 2005, payable on October 21, 2005. The payments of these dividends were in addition to the regular quarterly cash dividends. Per share amounts have been restated for the impact of the stock dividends.

Brokerage and Insurance Commissions—Brokerage commissions are recognized as income on settlement date. Insurance commissions on loan products (credit life, mortgage life, accidental death, and guaranteed auto protection) are recognized as income over the life of the loan.

Stock Based Compensation—Effective January 1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS No. 123R”), “Share-Based Payment”. Accordingly, we have recorded stock-based employee compensation cost using the fair value method in 2006. The cost is measured at the fair value of the options when granted, and this cost is expensed over the employee service period, which is normally the vesting period of the options. Compensation cost is recorded for prior option grants that vest after the date of adoption. For 2006, adopting this standard resulted in a reduction of income before income taxes of $129,212, a reduction in net income of $85,280, a decrease in basic and diluted earnings per share of $.01 and $.01, an increase in cash flow from operations of $129,212 and an increase in cash flows from financing of $0.

Prior to January 1, 2006, employee compensation expense under stock options was reported using the intrinsic value method; therefore, no stock-based compensation cost is reflected in net income for the years ending December 31, 2005 and 2004, as all options granted had an exercise price equal to the market price of the underlying common stock at date of grant.

The following table illustrates the effect on net income and earnings per share if expense was measured using the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation.

		Year Ended December 31,
		2005				2004
		(Dollars in thousands except per share data)
Net income:
As reported			$	9,144			$	7,790
Deduct: Stock-based compensation expense determined under fair value based method			(89		)		(190		)
Pro-forma			$	9,055			$	7,600
Earnings per share:
Basic	As Reported		$	2.08			$	1.76
	Pro-forma		2.05				1.72
Diluted	As Reported		$	2.07			$	1.75
	Pro-forma		2.04				1.71

Income Taxes—Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES—(Continued)

tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.

Employee Stock Ownership Plan—Compensation expense is based on the market price of shares as they are committed to be released to participant accounts. Dividends on allocated ESOP shares reduce retained earnings. Since the ESOP has not acquired shares in advance of allocation to participant accounts, the plan has no unallocated shares.

Earnings Per Common Share—Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share include the dilutive effect of additional potential common shares issuable under stock options.

Loss Contingencies—In the normal course of business, there are various outstanding legal proceedings and claims. In the opinion of management the disposition of such legal proceedings and claims will not materially affect our consolidated financial position, results of operations or liquidity.

Comprehensive Income—Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available-for-sale, which are also recognized as a separate component of equity, net of tax.

Derivatives—The Corporation only uses derivative instruments as described in “Mortgage Banking Activities.”

Loan Commitments and Related Financial Instruments—Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.

Fair Value of Financial Instruments—Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.

Operating Segments—Segments are parts of a company evaluated by management with separate financial information. Our internal financial information is primarily reported and evaluated in three lines of business, banking, mortgage banking, and brokerage. These segments are dominated by banking at a magnitude for which separate individual segment disclosures are not required.

Reclassifications—Some items in the prior year financial statements were reclassified to conform to the current presentation.

Adoption of New Accounting Standards—Effective January 1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS No. 123R”), “Share-Based Payment”. See “Stock Based Compensation” for further discussion of the effect of adopting this standard.

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108 Topic 1N, “Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 requires that a

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES—(Continued)

dual approach be used to compute the amount of a financial statement misstatement. More specifically, the amount should be computed using both the “rollover” (current year income statement perspective) and “iron curtain” (year-end balance sheet perspective) methods. A registrant’s financial statements require adjustment when either approach results in quantifying a misstatement that is material, after considering all relevant quantitative and qualitative factors. Registrants will not be required to restate prior period financial statements when initially applying SAB 108 if management properly applied its previous approach (i.e. rollover or iron curtain) given that all relevant qualitative factors were considered. SAB 108 states that, upon initial application, registrants may elect to (a) restate prior periods, or (b) record the cumulative effect of the initial application of SAB 108 in the carrying amounts of assets and liabilities, with the offsetting adjustment made to retained earnings. To the extent that registrants elect to record the cumulative effect of initially applying SAB 108, they will disclose the nature and amount of each individual error being corrected in the cumulative adjustment. The disclosure will also include when and how each error being corrected arose and the fact that the errors had previously been considered immaterial. The adoption of SAB 108 had no effect on our financial statements for the year ending December 31, 2006.

Effect of Newly Issued But Not Yet Effective Accounting Standards—In March 2006, the FASB issued Statement No. 156, “Accounting for Servicing of Financial Assets, an amendment of FASB Statement No. 140”, which changes the accounting for all servicing rights recorded as the result of purchasing or originating a loan servicing right. SFAS No. 156 amends the current accounting guidance for servicing rights in that it allows companies to carry their servicing rights at fair value, where presently servicing rights are recorded at cost allocated on a fair value basis at inception and assessed for impairment based on their fair value at each reporting date, using lower of cost or market value. This pronouncement is effective beginning January 1, 2007. Since we sell loans with servicing released, this standard will have no impact on our financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. More specifically, this statement clarifies the definition of fair value, establishes a fair valuation hierarchy based upon observable (e.g. quoted prices, interest rates, yield curves) and unobservable market inputs, and expands disclosure requirements to include the inputs used to develop estimates of fair value and the effects of the estimates on income for the period. This statement does not require any new fair value measurements. This pronouncement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We are in the process of evaluating the impact, if any; the adoption of SFAS No. 157 will have on our financial statements.

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (FIN 48), which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective beginning in 2007. We do not believe that adoption of this standard will have a material impact on our financial statements.

In September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.” This issue requires that a liability be recorded during the service period when a split-dollar

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES—(Continued)

life insurance agreement continues after participants’ employment or retirement. The required accrued liability will be based on either the post-employment benefit cost for the continuing life insurance or based on the future death benefit depending on the contractual terms of the underlying agreement. This issue is effective for fiscal years beginning after December 15, 2007. We are in the process of evaluating the impact, if any; the adoption of Issue 06-4 will have on our financial statements.

In September 2006, the FASB ratified the Emerging Issues Task Force’s (EITF) consensus on Issue 06-5, “Accounting for Purchases of Life Insurance” Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4, “Accounting for Purchases of Life Insurance”. FASB Technical Bulletin No. 85-4 requires that assets such as bank owned life insurance be carried at their cash surrender value (CSV) or the amount that could be realized, with changes in CSV reported in earnings. Issue 06-5 requires that a policyholder consider any additional amounts (e.g. claims stabilization reserves and deferred acquisition costs) included in the contractual terms of the policy in determining the amount that could be realized under the insurance contract. Certain life insurance contracts provide the policyholder with an amount that, upon surrender, is greater if all individual policies are surrendered at the same time rather than if the policies were surrendered over a period of time. Issue 06-5 requires that policyholders determine the amount that could be realized under the life insurance contract assuming the surrender of an individual-life by individual-life policy.

Issue 06-5 is effective for us beginning January 1, 2007. Issue 06-5 can be applied as either (a) a change in accounting principle through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption, or (b) a change in accounting principle through retrospective application to all periods. We are in the process of evaluating the impact, if any; the adoption of Issue 06-5 will have on our financial statements.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

2. SECURITIES

The amortized cost basis and fair values of securities are as follows:

				Gross			Gross
	Amortized			Unrealized			Unrealized
	Cost			Gains			Losses				Fair Value
	(Dollars in thousands)
Securities available-for-sale:
December 31, 2006:
U.S. Treasury and agencies		$	3,497		$	—		$	(13	)		$	3,484
Mortgage-backed		9,425			8			(189		)		9,244
Equity		1,553			629			(36		)		2,146
State and municipal		10,299			7			(277		)		10,029
Corporate		3,320			—			—				3,320
Total		$	28,094		$	644		$	(515	)		$	28,223
December 31, 2005:
U.S. Treasury and agencies		$	6,486		$	—		$	(49	)		$	6,437
Mortgage-backed		11,558			—			(256		)		11,302
Equity		1,353			638			—				1,991
State and municipal		5,803			14			(259		)		5,558
Corporate		3,036			—			—				3,036
Total		$	28,236		$	652		$	(564	)		$	28,324

				Gross			Gross
	Amortized			Unrecognized			Unrecognized
	Cost			Gains			Losses				Fair Value
Securities held-to-maturity:
December 31, 2006:
U.S. Treasury and agencies		$	18,097		$	4		$	(318	)		$	17,783
Mortgage-backed		4,127			3			(111		)		4,019
Corporate		2,000			15			—				2,015
Total		$	24,224		$	22		$	(429	)		$	23,817
December 31, 2005:
U.S. Treasury and agencies		$	26,095		$	—		$	(607	)		$	25,488
Mortgage-backed		5,136			2			(207		)		4,931
Corporate		2,000			15			—				2,015
Total		$	33,231		$	17		$	(814	)		$	32,434

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

2. SECURITIES—(Continued)

The amortized cost and fair value of securities at December 31, 2006, by contractual maturity, are shown below. Securities not due at a single maturity date, primarily mortgage-backed and equity securities, are shown separately.

	Available for Sale					Held-to-Maturity
	Amortized			Fair		Amortized			Fair
	Cost			Value		Cost			Value
	(Dollars in thousands)
Due in one year or less		$	1,375	$	1,374		$	4,000	$	3,948
Due after one year through five years		2,324		2,326			14,097		13,835
Due after five years through ten years		497		488
Due after ten years		12,920		12,645			2,000		2,015
Mortgage-backed		9,425		9,244			4,127		4,019
Equity		1,553		2,146			—		—
		$	28,094	$	28,223		$	24,224	$	23,817

The following schedule shows the proceeds from sales of available-for-sale securities and the gross realized gains on those sales:

	Year Ended December 31,
	2006			2005		2004
	(Dollars in thousands)
Proceeds from sales		$	—	$	1,431	$	745
Gross realized gains		$	—	$	381	$	202

The tax expense related to these realized gains was $0, $130,000, and $69,000, respectively.

Investment securities pledged to secure public deposits and FHLB advances had an amortized cost of $31.9 million and fair value of $31.3 million at December 31, 2006 and a $36.7 million amortized cost and a $35.8 fair value at December 31, 2005.

Securities with unrealized losses at year-end 2006 and 2005 aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position are as follows:

	Less than 12 Months						12 Months or More						Total
December 31, 2006	Fair		Unrealized				Fair		Unrealized				Fair		Unrealized
Description of Securities	Value		Loss				Value		Loss				Value		Loss
U. S. Treasury and agencies	$	—		$	—		$	19,263		$	(331	)	$	19,263		$	(331	)
Mortgage-backed	—			—			12,340			(300		)	12,340			(300		)
Equity	591			(36		)	—			—			591			(36		)
State and municipal	4,139			(117		)	4,836			(160		)	8,975			(277		)
Total temporarily impaired	$	4,730		$	(153	)	$	36,439		$	(791	)	$	41,169		$	(944	)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

2. SECURITIES—(Continued)

	Less than 12 Months						12 Months or More						Total
December 31, 2005	Fair		Unrealized				Fair		Unrealized				Fair		Unrealized
Description of Securities	Value		Loss				Value		Loss				Value		Loss
U. S. Treasury and agencies	$	6,377		$	(104	)	$	25,548		$	(552	)	$	31,925		$	(656	)
Mortgage-backed	10,239			(218		)	5,753			(245		)	15,992			(463		)
State and municipal	4,620			(259		)	—			—			4,620			(259		)
Total temporarily impaired	$	21,236		$	(581	)	$	31,301		$	(797	)	$	52,537		$	(1,378	)

All unrealized losses are reviewed at least on a quarterly basis to determine whether the losses are other than temporary and more frequently when economic or market concerns warrant such evaluation. Consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and our intent and ability to retain the investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer’s financial condition, we may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition. The unrealized losses on our investments in U.S. Treasury and agencies, mortgage-backed securities and obligations of state and political subdivisions were caused by interest rate increases. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because we have the ability and intent to hold these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2006 and 2005.

3. LOANS

Loans are summarized as follows:

	December 31,
	2006			2005
	(Dollars in thousands)
Commercial	$	40,902		$	36,004
Real estate commercial	410,146			353,637
Real estate construction	23,953			13,579
Residential mortgage	137,334			142,727
Consumer and home equity	62,805			66,208
Indirect consumer	30,857			31,577
Loans held for sale	673			597
	706,670			644,329
Less:
Net deferred loan origination fees	(960		)	(1,212		)
Allowance for loan losses	(7,684		)	(7,377		)
	(8,644		)	(8,589		)
Loans Receivable	$	698,026		$	635,740

We utilize eligible real estate loans to collateralize advances and letters of credit from the Federal Home Loan Bank. We had $373 and $369 million in residential mortgage loans and commercial real estate loans pledged under this arrangement at December 31, 2006 and 2005.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

3. LOANS—(Continued)

The allowance for loan loss is summarized as follows:

	As of and For the
	Years Ended December 31,
	2006			2005			2004
	(Dollars in thousands)
Balance, beginning of year	$	7,377		$	6,489		$	5,568
Provision for loan losses	540			1,258			1,656
Charge-offs	(614		)	(666		)	(949		)
Recoveries	381			296			214
Balance, end of year	$	7,684		$	7,377		$	6,489

Impaired loans are summarized below. There were no impaired loans for the periods presented without an allowance allocation.

	As of and For the
	Years Ended December 31,
	2006		2005		2004
	(Dollars in thousands)
Year-end impaired loans	$	4,838	$	6,232	$	5,240
Amount of allowance for loan loss allocated	128		350		168
Average impaired loans outstanding	5,808		5,647		4,783
Interest income recognized	227		219		197
Interest income received	227		219		197

We report non-performing loans as impaired. Our non-performing loans at year-end were as follows:

	December 31,
	2006			2005
	(Dollars in thousands)
Restructured		$	2,470		$	3,104
Loans past due over 90 days still on accrual		—			—
Non accrual loans		2,368			3,128
Total		$	4,838		$	6,232

4. PREMISES AND EQUIPMENT

Premises and equipment consist of the following:

	December 31,
	2006			2005
	(Dollars in thousands)
Land	$	5,527		$	3,675
Buildings	17,736			15,826
Furniture, fixtures and equipment	8,516			8,649
	31,779			28,150
Less accumulated depreciation	(9,279		)	(9,016		)
	$	22,500		$	19,134

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

4. PREMISES AND EQUIPMENT—(Continued)

Certain premises are leased under various operating leases. Rental expense was $281,000, $274,000 and $259,000, for the years ended December 31, 2006, 2005 and 2004, respectively. Future minimum commitments under these leases are:

	Year Ended
	December 31,
	(Dollars in thousands)
2007		$	330
2008		315
2009		317
2010		317
2011		284
Thereafter		229
		$	1,792

5. DEPOSITS

Time Deposits of $100,000 or more were $158.3 million and $101.6 million at December 31, 2006 and 2005, respectively. At December 31, 2006, scheduled maturities of time deposits are as follows:

	Amount
	(Dollars in thousands)
2007		$	269,033
2008		67,989
2009		34,050
2010		10,838
2011		5,845
Thereafter		470
		$	388,225

6. SHORT-TERM BORROWINGS

Short-term borrowings consist of federal funds purchased and securities sold under agreements to repurchase. We had short-term borrowings of $68.5 million and $19.5 million from the FHLB of Cincinnati at December 31, 2006 and 2005. These borrowings averaged a rate of 5.31% and 4.05% for 2006 and 2005.

7. ADVANCES FROM FEDERAL HOME LOAN BANK

Under the collateral requirements of the Federal Home Loan Bank (FHLB) of Cincinnati, we have the capacity to borrow an additional $41.6 million from the FHLB at December 31, 2006. During January 2001, we entered into a $25.0 million convertible fixed rate advance with a fixed rate of 5.05% and a maturity of ten years. This advance was fixed for a period of three years. At the end of the fixed rate term and quarterly thereafter, the FHLB has the right to convert this advance to a variable rate advance tied to the three-month LIBOR index. Upon conversion, we can prepay the advance at no penalty.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

7. ADVANCES FROM FEDERAL HOME LOAN BANK—(Continued)

Advances from the FHLB at year-end are as follows:

	December 31,
	2006					2005
	Weighted-					Weighted-
	Average					Average
	Rate			Amount		Rate			Amount
	(Dollars in Thousands)
Fixed rate advances:
Mortgage matched advances with interest rates from 5.30% to 7.80% due through 2009		6.09	%	$	19		6.35	%	$	42
Convertible fixed rate advances with an interest rate of 5.05% due through 2011		5.05	%	25,000			4.92	%	75,000
Other fixed rate advances with interest rates from 4.19% to 5.72% due through 2020		4.93	%	3,205			4.93	%	3,333
Total borrowings				$	28,224				$	78,375

The aggregate minimum annual repayments of borrowings as of December 31, 2006 is as follows:

	(Dollars in thousands)
2007		$	139
2008		137
2009		131
2010		131
2011		25,131
Thereafter		2,555
		$	28,224

8. SUBORDINATED DEBENTURES

In March 2002, a trust we formed completed the private placement of 10,000 shares of cumulative trust preferred securities with a liquidation preference of $1,000 per security for a total outstanding of $10 million. The proceeds of the offering were loaned to us in exchange for floating rate junior subordinated deferrable interest debentures. In accordance with FASB Interpretation 46, the trust is not consolidated with our financial statements but rather the subordinated debentures are shown as a liability. Issuance costs of $302,000 paid from the proceeds are being amortized to maturity. Distributions on the Trust Preferred Securities are payable quarterly in arrears at the annual rate (adjusted quarterly) of three-month LIBOR plus 3.60% (8.97% as of the last adjustment), and are included in interest expense. The annual rate cannot exceed 11% prior to March 26, 2007. The subordinated debentures are considered as Tier I capital for the Corporation under current regulatory guidelines.

The subordinated debentures, which mature March 26, 2032, are redeemable prior to the maturity date at our option on or after March 26, 2007, at their principal amount plus accrued interest. Similar subordinated debentures are currently being offered at approximately 1.70% plus three-month LIBOR. Since we are currently paying 3.60% plus three-month LIBOR, we anticipate calling our current subordinated debentures and refinancing at a lower interest rate after the March 26, 2007, redemption date.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

9. INCOME TAXES

We file a consolidated federal income tax return and income tax is apportioned among all companies based on their taxable income or loss. Provision for income taxes is as follows:

	Year Ended December 31,
	2006			2005		2004
	(Dollars in thousands)
Current	$	4,654		$	4,178	$	3,334
Deferred	(20		)	234		401
Total income tax expense	$	4,634		$	4,412	$	3,735

The provision for income taxes differs from the amount computed at the statutory rates as follows:

	Year Ended December 31,
	2006			2005			2004
	(Dollars in thousands)
Federal statutory rate		34.0	%		34.0	%		34.0	%
Tax-exempt interest income		(0.7	)		(0.3	)		(0.1	)
Increase in cash surrender value of life insurance		(0.7	)		(0.7	)		(0.9	)
Dividends to ESOP		(0.3	)		(0.3	)		(0.4	)
Stock option expense		0.3			—			—
Tax contingency reserve		(1.9	)		—			—
Other		0.2			(0.2	)		(0.2	)
Effective rate		30.9	%		32.5	%		32.4	%

During the fourth quarter we re-evaluated our tax contingency reserves and determined that approximately $281,000 was no longer required. As a result, tax expense was reduced by this amount, resulting in an effective tax rate of 25% in the fourth quarter of 2006 compared to 32% in 2005.

Temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities that give rise to significant portions of deferred income taxes relate to the following:

	December 31,
	2006			2005
	(Dollars in thousands)
Deferred tax assets:
Allowance for loan losses		$	2,612		$	2,508
Accrued liabilities and other		143			109
		2,755			2,617
Deferred tax liabilities:
Depreciation		$	1,527		$	1,509
Net unrealized gain on securities available-for-sale		44			30
Federal Home Loan Bank stock		1,449			1,304
Intangibles		905			704
Deferred gain on like-kind exchange		30			30
Other		173			419
		4,128			3,996
Net deferred tax liability		$	1,373		$	1,379

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

9. INCOME TAXES—(Continued)

Federal income tax laws provided savings banks with additional bad debt deductions through 1987, totaling $9.3 million for us. Accounting standards do not require a deferred tax liability to be recorded on this amount, which would otherwise total $3.2 million at December 31, 2006 and 2005. If we were liquidated or otherwise ceased to be a bank or if tax laws were to change, the $3.2 million would be recorded as a liability with an offset to expense.

10. STOCKHOLDERS’ EQUITY

(a) Regulatory Capital Requirements—The Corporation and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action.

Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios (set forth in the following table) of Total and Tier I capital (as defined in the regulations) to risk weighted assets (as defined) and of Tier I capital (as defined) to average assets (as defined). As of December 31, 2006 and 2005, the Corporation and the Bank met all capital adequacy requirements to which they are subject.

The most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, we must maintain minimum Total Risk Based, Tier I Risk Based and Tier I Leverage rations as set forth in the table. There are no conditions or events since that notification that management believes have changed our capital ratings.

The actual and required capital amounts and ratios are presented below.

													To Be Considered
													Well Capitalized
													Under Prompt
							For Capital						Correction
	Actual						Adequacy Purposes						Action Provisions
	Amount			Ratio			Amount			Ratio			Amount		Ratio
	(Dollars in thousands)
As of December 31, 2006:
Total risk-based capital (to risk- weighted assets)
Consolidated		$	81,583		11.6	%		$	56,504		8.0	%		N/A		N/A
Bank		78,653			11.2			56,376			8.0			70,470		10.0
Tier I capital (to risk-weighted assets)
Consolidated		73,639			10.4			28,252			4.0			N/A		N/A
Bank		70,709			10.0			28,188			4.0			42,282		6.0
Tier I capital (to average assets)
Consolidated		73,639			9.2			32,014			4.0			N/A		N/A
Bank		70,709			8.9			31,962			4.0			39,953		5.0

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

10. STOCKHOLDERS’ EQUITY—(Continued)

													To Be Considered
													Well Capitalized
													Under Prompt
							For Capital						Correction
	Actual						Adequacy Purposes						Action Provisions
	Amount			Ratio			Amount			Ratio			Amount		Ratio
	(Dollars in thousands)
As of December 31, 2005:
Total risk-based capital (to risk- weighted assets)
Consolidated		$	73,678		11.5	%		$	51,185		8.0	%		N/A		N/A
Bank		71,070			11.1			51,026			8.0			63,782		10.0
Tier I capital (to risk-weighted assets)
Consolidated		66,300			10.4			25,592			4.0			N/A		N/A
Bank		63,692			10.0			25,513			4.0			38,269		6.0
Tier I capital (to average assets)
Consolidated		66,300			8.8			30,011			4.0			N/A		N/A
Bank		63,692			8.5			29,926			4.0			37,408		5.0

(b) Dividend Restrictions—Our principal source of funds for dividend payments is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net profits, combined with the retained net profits of the preceding two years, subject to the capital requirements described above. During 2007, the Bank could, without prior approval, declare dividends of approximately $12.3 million plus any 2007 net profits retained to the date of the dividend declaration.

(c) Liquidation Account—In connection with our conversion from mutual to stock form of ownership during 1987, we established a “liquidation account”, currently in the amount of $567,289 for the purpose of granting to eligible deposit account holders a priority in the event of future liquidation. Only in such an event, an eligible account holder who continues to maintain a deposit account will be entitled to receive a distribution from the liquidation account. The total amount of the liquidation account decreases in an amount proportionately corresponding to decreases in the deposit account balances of the eligible account holders.

11. EARNINGS PER SHARE

The reconciliation of the numerators and denominators of the basic and diluted EPS is as follows:

	Year Ended
	December 31,
	2006		2005			2004
	(In thousands, except per share data)
Net income available to common shareholders	$	10,337		$	9,144		$	7,790
Basic EPS:
Weighted average common shares	4,383			4,398			4,428
Diluted EPS:
Weighted average common shares	4,383			4,398			4,428
Dilutive effect of stock options	44			30			19
Weighted average common and incremental shares	4,427			4,428			4,447
Earnings Per Share:
Basic	$	2.36		$	2.08		$	1.76
Diluted	$	2.34		$	2.07		$	1.75

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

11. EARNINGS PER SHARE—(Continued)

Stock options for 26,000 and 10,000 shares of common stock were not included in the December 31, 2006 and 2004 computation of diluted earnings per share because their impact was anti-dilutive. All of the outstanding stock options for the year ended December 31, 2005 were included in the computation of diluted earnings per share.

12. EMPLOYEE BENEFIT PLANS

(a) Pension Plan—We are a participant in the Pentegra Defined Benefit Plan for Financial Institutions (formerly known as Financial Institutions Retirement Fund) which is a non-contributory, multiple-employer defined benefit pension plan, covering employees hired before June 1, 2002. Because the plan was curtailed, employees hired on or after that date are not eligible for membership in the fund. Eligible employees are 100% vested at the completion of five years of participation in the plan. Our policy is to contribute annually the minimum funding amounts. Employer contributions and administrative expenses charged to operations for the years ended December 31, 2006, 2005 and 2004 totaled $340,000, $210,000, and $253,000, respectively. Accrued liabilities associated with the plan as of December 31, 2006 and 2005 were $19,000 and $52,000, respectively. There were no accrued liabilities associated with the plan as of December 31, 2004.

(b) KSOP—We have a combined 401(k)/Employee Stock Ownership Plan. The plan is available to all employees meeting certain eligibility requirements. The plan allows employee contributions up to 50% of their compensation up to the annual dollar limit set by the IRS. The employer matches 100% of the employee contributions up to 6% of the employee’s compensation. If the employee does not contribute at least 2% of the employee’s compensation, then the employer makes a minimum contribution for the employee of 2% of the employee’s compensation. Employees are 100% vested in matching contributions upon meeting the eligibility requirements of the plan. Shares of our common stock are acquired in non-leveraged transactions. At the time of purchase, the shares are released and allocated to eligible employees determined by a formula specified in the plan agreement. Accordingly, the plan has no unallocated shares. The number of shares to be purchased and allocated is at the Board of Directors discretion. Employer matching contributions and administrative expenses charged to operations for the plan for the years ended December 31, 2006, 2005 and 2004 were $446,000, $334,000, and $302,000, respectively.

Shares in the plan and the fair value of shares released during the year charged to compensation expense were as follows:

	Year Ended
	December 31,
	2006		2005		2004
ESOP shares (ending)	181,861		178,803		182,709
Shares released	3,058		2,923		2,148
Compensation expense	$	96,000	$	83,081	$	54,000

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

12. EMPLOYEE BENEFIT PLANS—(Continued)

(c) Stock Option Plan—Our 2006 Stock Incentive Plan, which is shareholder approved, succeeded our 1998 Stock Option and Incentive Plan. Under the 2006 Plan, we may grant either incentive or non-qualified stock options to key employees and directors for a total of 588,500 shares of our common stock at not less than fair value at the date such options are granted. Options available for future grant under the 1998 Plan totaled 35,000 shares and were rolled into the 2006 Plan. We believe that the ability to award stock options and other forms of stock-based incentive compensation can assist us in attracting and retaining key employees. Stock-based incentive compensation is also a means to align the interests of key employees with those of our shareholders by providing awards intended to reward recipients for our long-term growth. The option to purchase shares vest over periods of one to five years and expire ten years after the date of grant. We issue new shares of common stock upon the exercise of stock options. At December 31, 2006 options available for future grant under the 2006 Plan totaled 562,500. Compensation cost related to options granted under the 1998 and 2006 Plans that was charged against earnings for the year ended December 31, 2006 was $129,212.

The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model that uses various weighted-average assumptions. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. The expected volatility is based on the fluctuation in the price of a share of stock over the period for which the option is being valued and the expected life of the options granted represents the period of time the options are expected to be outstanding.

The weighted-average assumptions for options granted during the years ended December 31, 2006 and 2004 and the resulting estimated weighted average fair value per share is presented below. There were no options granted for the year ended December 31, 2005.

	December 31,
	2006			2004
Assumptions:
Risk-free interest rate	4.71		%	4.13		%
Expected dividend yield	2.47		%	2.84		%
Expected life (years)	10			10
Expected common stock market price volatility	25		%	26		%
Estimated fair value per share	$	9.30		$	7.03

A summary of option activity under the 1998 and 2006 Plans for the year ended December 31, 2006 is presented below:

						Weighted
			Weighted			Average
	Number		Average			Remaining		Aggregate
	of		Exercise			Contractual		Intrinsic
	Options		Price			Term		Value
								(Dollars In Thousands)
Outstanding, beginning of period	144,075			$	18.42
Granted during period	26,000			30.80
Exercised during the period	(915	)		13.41
Outstanding, end of period	169,160			$	20.35		6.0		$	1,768
Eligible for exercise at period end	100,365			$	17.70		4.3		$	1,314

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

12. EMPLOYEE BENEFIT PLANS—(Continued)

The total intrinsic value of options exercised during the periods ended December 31, 2006, 2005 and 2004 was $12,695, $40,030 and $0 respectively. There was no tax benefit recognized from the option exercises as they are considered incentive stock options.

As of December 31, 2006 there was $354,308 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the 1998 and 2006 Plans. That cost is expected to be recognized over a weighted-average period of 3.7 years. Cash received from option exercise under all share-based payment arrangements for the periods ended December 31, 2006, 2005 and 2004 were $12,273, $84,813 and $0 respectively.

(d) Employee Stock Purchase Plan—We maintain an Employee Stock Purchase Plan whereby eligible employees have the option to common stock of the Corporation through payroll deduction at a 5% discount. The purchase price of the shares under the plan will be 95% of the closing price of the common stock at the date of purchase. The plan provides for the purchase of up to 100,000 shares of common stock, which may be obtained by purchases on the open market. Funding for the purchase of common stock is from employee contributions. The plan was considered non-compensatory under APB No. 25, and as a result no compensation expense was recorded in 2006.

13. CASH FLOW ACTIVITIES

The following information is presented as supplemental disclosures to the statement of cash flows.

(a) Cash Paid for:

	Year Ended December 31,
	2006		2005		2004
	(Dollars in thousands)
Interest expense	$	24,224	$	17,886	$	14,795
Income taxes	$	4,410	$	4,625	$	3,532

(b) Supplemental disclosure of non-cash activities:

	Year Ended December 31,
	2006		2005		2004
	(Dollars in thousands)
Loans to facilitate sales of real estate owned and repossessed assets	$	1,352	$	1,561	$	1,124
Transfers from loans to real estate acquired through foreclosure and repossessed assets	$	1,209	$	1,981	$	1,396

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

14. CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY)

The following condensed statements summarize the balance sheets, operating results and cash flows of First Financial Service Corporation (Parent Company only).

Condensed Balance Sheets

	December 31,
	2006		2005
	(Dollars in thousands)
Assets
Cash and interest bearing deposits	$	401	$	179
Investment in Bank	79,168		72,077
Securities available-for sale	1,560		1,431
Land	752		752
Other assets	318		328
	$	82,199	$	74,767
Liabilities and Stockholders’ Equity
Subordinated debentures	$	10,000	$	10,000
Other liabilities	101		26
Stockholders’ equity	72,098		64,741
	$	82,199	$	74,767

Condensed Statements of Income

	Year Ended December 31,
	2006			2005			2004
	(Dollars in thousands)
Dividend from Bank	$	4,212		$	4,022		$	4,500
Interest income	57			80			114
Interest expense	(895		)	(712		)	(529		)
Gain on sale of investments	—			381			202
Other expenses	(408		)	(223		)	(223		)
Income before income tax benefit	2,966			3,548			4,064
Income tax benefit	483			222			220
Income before equity in undistributed net income of Bank	3,449			3,770			4,284
Equity in undistributed net income of Bank	6,888			5,374			3,506
Net income	$	10,337		$	9,144		$	7,790

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

14. CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY)—(Continued)

Condensed Statements of Cash Flows

	Year Ended December 31,
	2006			2005			2004
	(Dollars in thousands)
Operating Activities:
Net income	$	10,337		$	9,144		$	7,790
Adjustments to reconcile net income to cash provided by operating activities:
Equity in undistributed net income of Bank	(6,888		)	(5,374		)	(3,506		)
Gain on sale of investments available-for-sale	—			(381		)	(202		)
Compensation expense for stock options	129			—			—
Changes in:
Other assets	(94		)	101			10
Accounts payable and other liabilities	75			(136		)	(106		)
Net cash from operating activities	3,559			3,354			3,986
Investing Activities:
Purchases of securities available-for-sale	(200		)	(506		)	(640		)
Sales of securities available-for-sale	—			1,431			745
Net purchases of premises and equipment	—			(752		)	—
Net change in receivable from Bank	—			—			165
Net cash from investing activities	(200		)	173			270
Financing Activities:
Issuance of common stock for options and employee benefit plans	64			85			—
Dividends paid	(3,185		)	(2,830		)	(2,708		)
Common stock repurchases	(16		)	(760		)	(1,560		)
Net cash from financing activities	(3,137		)	(3,505		)	(4,268		)
Net change in cash and interest bearing deposits	222			22			(12		)
Cash and interest bearing deposits, beginning of year	179			157			169
Cash and interest bearing deposits, end of year	$	401		$	179		$	157

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

15. FAIR VALUES OF FINANCIAL INSTRUMENTS

The estimated fair value of financial instruments is as follows:

	December 31, 2006		December 31, 2005
	Carrying	Fair	Carrying	Fair
	Value	Value	Value	Value
	(Dollars in thousands)
Financial assets:
Cash and due from banks	$ 19,082	$ 19,082	$ 20,451	$ 20,451
Securities available-for-sale	28,223	28,223	28,324	28,324
Securities held-to-maturity	24,224	23,817	33,231	32,434
Loans held for sale	673	687	597	608
Loans, net	697,353	700,579	635,143	640,079
Federal Home Loan Bank stock	7,621	7,621	7,194	7,194
Accrued interest receivable	4,094	4,094	3,051	3,051
Financial liabilities:
Deposits	641,037	634,617	591,106	587,642
Short-term borrowings	68,500	68,500	19,500	19,500
Advances from Federal Home Loan Bank	28,224	27,392	78,375	78,703
Subordinated debentures	10,000	10,000	10,000	10,000
Accrued interest payable	273	273	389	389

The methods and assumptions used in estimating fair value disclosures for financial instruments are presented below:

Carrying amount is the estimated fair value for cash and cash equivalents, interest bearing deposits, Federal Home Loan Bank stock, accrued interest receivable and payable, demand deposits, short-term debt and variable rate loans or deposits that reprice frequently and fully. Security fair values are based on market prices or dealer quotes and if no such information is available, on the rate and term of the security and information about the issuer. The value of loans held for sale is based on the underlying sale commitments. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent reprising or reprising limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk. Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values. Fair values of advances from Federal Home Loan Bank are based on current rates for similar financing. The principal amount of the subordinated debentures is the estimated fair value. The fair value of off-balance-sheet items is based on the current fees or cost that would be charged to enter into or terminate such arrangements and is not material.

16. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK

We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments primarily include commitments to extend credit, and lines and letters of credit, and involve, to varying degrees, elements of credit and interest-rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of these instruments reflect the extent of our involvement in particular classes of financial instruments.

Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual notional amount of those

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

16. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK—(Continued)

instruments. Creditworthiness for all instruments is evaluated on a case-by-case basis in accordance with our credit policies. We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments. Collateral from the customer may be required based on management’s credit evaluation of the customer and may include business assets of commercial customers as well as personal property and real estate of individual customers or guarantors.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

The contractual amounts of financial instruments with off-balance-sheet risk at year end were as follows:

	December 31, 2006			December 31, 2005
	Fixed		Variable	Fixed		Variable
	Rate		Rate	Rate		Rate
	(Dollars in thousands)
Commitments to make loans		$ —	$ 476		$ 38	$ 882
Unused lines of credit		—	96,501		—	118,598
Standby letters of credit		—	11,927		—	12,536
		$ —	$ 108,904		$ 38	$ 132,016

At December 31, 2006 and 2005, we had $59.5 million, and $54.7 million in letters of credit from the Federal Home Loan Bank issued to collateralize public deposits. These letters of credit are secured by a blanket pledge of eligible one-to-four family residential mortgage loans. (For additional information see Note 3 on Loans and Note 6 on Advances from the Federal Home Loan Bank.)

17. RELATED PARTY TRANSACTIONS

Certain directors, executive officers and principal shareholders of the Company, including associates of such persons, are our loan and deposit customers. Related party deposits at December 31, 2006 and 2005 were $3.0 million and $3.1 million. A summary of the related party loan activity, for loans aggregating $60,000 or more to any one related party, is as follows:

	Year Ended December 31,
	2006		2005
	(Dollars in thousands)
Beginning of year	$ 291		$ 315
New loans	22		—
Repayments	(25	)	(24	)
End of year	$ 288		$ 291

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

18. SUMMARY OF QUARTERLY FINANCIAL DATA—(Unaudited)

Year Ended December 31, 2006:	March 31,		June 30,	September 30,		December 31,
	(Dollars in thousands except per share data)
Total interest income		$ 12,492	$ 13,111		$ 13,822		$ 14,407
Total interest expense		5,256	5,740		6,341		6,771
Net interest income		7,236	7,371		7,481		7,636
Provision for loan losses		89	9		249		193
Non-interest income		1,712	2,076		2,033		1,916
Non-interest expense		5,409	5,314		5,437		5,791
Net income		2,338	2,755		2,571		2,672
Earnings per share:
Basic		0.54	0.63		0.59		0.61
Diluted		0.53	0.63		0.58		0.60

Year Ended December 31, 2005:	March 31,		June 30,	September 30,		December 31,
Total interest income		$ 10,630	$ 11,027		$ 11,593		$ 12,118
Total interest expense		3,994	4,272		4,634		4,963
Net interest income		6,636	6,755		6,959		7,155
Provision for loan losses		275	41		440		502
Non-interest income		2,021	1,976		2,061		2,008
Non-interest expense		5,144	5,276		5,156		5,181
Net income		2,186	2,294		2,311		2,353
Earnings per share:
Basic		0.50	0.52		0.53		0.54
Diluted		0.50	0.52		0.52		0.53

Kentucky		61-1168311
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
2323 Ring Road, Elizabethtown, Kentucky		42701
(Address of principal executive offices)		Zip Code

Date: March 16, 2007	By:	/s/ B. KEITH JOHNSON
		B. Keith Johnson
		President and Chief Executive Officer
Date: March 16, 2007	By:	/s/ GREGORY SCHREACKE
		Gregory Schreacke
		Chief Financial Officer
		Principal Accounting Officer

		Page
Part I.
Item 1.	Business	2
Item 1A.	Risk Factors	13
Item 1B.	Unresolved Staff Comments	16
Item 2.	Properties	16
Item 3.	Legal Proceedings	16
Item 4.	Submission of Matters to a Vote of Security Holders	16
Part II.
Item 5.	Market Price of and Dividends on the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	17
Item 6.	Selected Financial Data	18
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	19
Item 7A.	Quantitative and Qualitative Disclosures about Market Risk	37
Item 8.	Financial Statements and Supplementary Data	39
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	73
Item 9A.	Controls and Procedures	73
Item 9B.	Other Information	73
Part III.
Item 10.	Directors and Executive Officers of the Registrant	73
Item 11.	Executive Compensation	73
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	74
Item 13.	Certain Relationships and Related Transactions	74
Item 14.	Principal Accountant Fees and Services	74
Part IV.
Item 15.	Exhibits and Financial Statement Schedules	74
Signatures		76

Audited Consolidated Financial Statements:
	·	Report on Management’s Assessment of Internal Control Over Financial Reporting	40
	·	Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting	41
	·	Report of Independent Registered Public Accounting Firm on Financial Statements	43
	·	Consolidated Balance Sheets	44
	·	Consolidated Statements of Income	45
	·	Consolidated Statements of Comprehensive Income	46
	·	Consolidated Statements of Changes in Stockholders’ Equity	47
	·	Consolidated Statements of Cash Flows	48
	·	Notes to Consolidated Financial Statements	49-72

	FIRST FINANCIAL SERVICE CORPORATION
Date: 3/16/07	By:	/s/ B. KEITH JOHNSON
		B. Keith Johnson
		President and Chief Executive Officer
		Duly Authorized Representative

By:	/s/ B. KEITH JOHNSON	By:	/s/ BOB BROWN
	B. Keith Johnson		Bob Brown
	Principal Executive Officer & Director		Director
Date:	3/16/07	Date:	3/16/07
By:	/s/ WRENO M. HALL	By:	/s/ DIANE E. LOGSDON
	Wreno M. Hall		Diane E. Logsdon
	Director		Director
Date:	3/16/07	Date:	3/16/07
By:	/s/ J. ALTON RIDER	By:	/s/ JOHN L. NEWCOMB, JR.
	J. Alton Rider		John L. Newcomb, Jr.
	Director		Director
Date:	3/16/07	Date:	3/16/07
By:	/s/ WALTER D. HUDDLESTON	By:	/s/ MICHAEL THOMAS, DVM
	Walter D. Huddleston		Michael Thomas, DVM
	Director		Director
Date:	3/16/07	Date:	3/16/07
By:	/s/ STEPHEN MOUSER	By:	/s/ DONALD SCHEER
	Stephen Mouser		Donald Scheer
	Director		Director
Date:	3/16/07	Date:	3/16/07
By:	/s/ GAIL SCHOMP	By:	/s/ GREGORY SCHREACKE
	Gail Schomp		Gregory Schreacke
	Director		Chief Financial Officer Principal Accounting Officer
Date:	3/16/07	Date:	3/16/07

Exhibit No.		Description
3	(a), 4(a)	Articles of Incorporation *
3	(b), 4(b)	Amended and Restated Bylaws**
4	(c)	Rights Agreement between First Financial Service Corporation and Illinois Stock Tranfser Company dated April 15, 2003***
10	(a)	2006 Stock Option and Incentive Compensation Plan****
10	(b)	Form of Stock Option Agreement**
21		Subsidiaries of the Registrant
23	(a)	Consent of Crowe Chizek and Company LLC, Independent Registered Public Accounting Firm
31	.1	Certification of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act
31	.2	Certification of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act
32		Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 (As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002)