REGULATORY MATTERS AND RECENT DEVELOPMENTS

12 Months Ended

Dec. 31, 2011

REGULATORY MATTERS AND RECENT DEVELOPMENTS

2. REGULATORY MATTERS AND RECENT DEVELOPMENTS

In its Consent Order with the FDIC and KDFI, the Bank agreed to achieve and maintain a Tier 1 leverage ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2011. At December 31, 2011, we were not in compliance with the Tier 1 and total risk-based capital requirements. We notified the bank regulatory agencies that the increased capital levels would not be achieved and anticipate that the FDIC and KDFI will reevaluate our progress toward achieving the higher capital ratios at June 30, 2012.

On March 9, 2012, the Bank entered into a new Consent Order with the FDIC and KDFI. The new Consent Order requires the Bank to achieve the same minimum capital ratios set forth in the January 2011 Consent Order by June 30, 2012. The Bank also agreed that if it should be unable to reach the required capital levels by that date and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution. The new Consent Order requires the Bank to continue to adhere to the plans implemented in response to the January 2011 Consent Order, and includes the substantive provisions of the January 2011 Consent Order. A copy of the March 9, 2012 Consent Order is included as Exhibit 10.8 to this Annual Report on Form 10-K.

The Bank’s Consent Order with the FDIC and KDFI requires us to obtain the consent of the Regional Director of the FDIC and the Commissioner of the KDFI to declare and pay cash dividends to the Corporation. We are also no longer allowed to accept, renew or rollover brokered deposits (including deposits through the CDARs program) without prior regulatory approval.

On April 20, 2011, the Corporation entered into a formal agreement with the Federal Reserve Bank of St. Louis, which requires the Corporation to obtain regulatory approval before declaring any dividends. We also may not redeem shares or obtain additional borrowings without prior approval.

Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a consent order. The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any action taken by bank regulatory agencies could damage our reputation and have a material adverse effect on our business.

In order to meet these capital requirements, we have engaged an investment banking firm with expertise in the financial services sector to assist with a review of strategic opportunities available to us. We continue reducing our costs where possible while taking into consideration the resources necessary to execute our strategies. We have suspended the annual employee stock ownership contribution, frozen executive management compensation the past three years and into 2012, frozen officer compensation for the past year and into 2012, eliminated board of director fees, reduced marketing expenses, reduced community donation expense, reduced compensation expense through reductions in associates, and implemented various other cost savings initiatives. Expense reductions for 2011 were $1.1 million. Additional cost reductions for 2012 are projected to be in excess of $1.3 million. We are also evaluating remaining terms on existing contracts and identifying expenses we cannot reduce currently, but expect to be able to in 2012 and 2013, such as examination fees and loan workout and other real estate owned expenses. These efforts will remain ongoing.

As part of our ongoing capital initiatives, on February 9, 2012, we signed a definitive agreement to sell our four Indiana banking centers to First Savings Bank, F.S.B., the banking subsidiary of First Savings Financial Group, Inc. The purchase price will represent a 3.65% percent premium based on the actual level of consumer and commercial deposits at closing, which totaled $99.7 million at December 31, 2011. Under the agreement, First Savings Financial Group, Inc. will also acquire government, corporate, other financial institution deposits and municipal deposits, which were $17.5 million at December 31, 2011, at book value. A total of $35.4 million of performing loans will be purchased at a discount of 0.80% based on the actual level of loans at closing. The consummated transaction would result in a one-time gain of approximately $3.4 million based on information at December 31, 2011. We believe the transaction places us in a better position to meet the conditions of the regulatory consent order in a manner that is beneficial to our shareholders. This transaction is projected to increase our Tier I capital ratio from 5.86% to 6.74% and increase our total risk-based capital ratio from 10.18% to 11.32% based on information at December 31, 2011, and is expected to close early in the third quarter of 2012.

On February 10, 2012, we announced the following changes to our management and the board of directors.

• Senator Walter Dee Huddleston had stepped down as Chairman of the Board while continuing to serve as a director.

• J. Stephen Mouser, President of Mouser Custom Cabinetry, LLC, and a director since 1997, was appointed as the Board’s new Chairman.

• B. Keith Johnson, Chief Executive Officer of the Corporation and the Bank since 1997, had stepped down from those positions. Mr. Johnson assumed the position of the Board’s Vice Chairman, while continuing to work at the Bank in an advisory role.

• Gregory S. Schreacke, President of the Corporation and the Bank since 2008, assumed principal management responsibility for the Corporation and the Bank. Mr. Schreacke also joined the boards of directors of both the Corporation and the Bank.

• Dann Small was appointed as Chief Lending Officer of the Bank and will direct the Bank’s lending program and supervise all phases of the lending operation. Mr. Small has over 30 years of experience in finance, lending, credit underwriting and executive management.

• Robert L. Critchfield was appointed as Chief Credit Officer of the Bank, with responsibility for the overall management of its loan, credit and risk policies. Mr. Critchfield has over forty years of experience in the banking industry, including seventeen years as President and CEO of two commercial banks.

Our plans for 2012 include the following:

• Continue to pursue all available strategies to recapitalize the Bank. We are evaluating various specific initiatives to increase our regulatory capital and to reduce our total assets. Strategic alternatives include divesting of branch offices, selling loans and raising capital by selling stock.

• Continue to serve our community banking customers and operate the Corporation and the Bank in a safe and sound manner. We have worked diligently to maintain the strength of our retail and deposit franchise. The strength of this franchise contributes to earnings to help withstand our credit quality issues. In addition, the inherent value of the retail franchise will provide value to the Bank to accomplish the various capital initiatives.

• Continue to reduce our lending concentration in commercial real estate by obtaining pay downs and payoffs. In addition to allowing loans in these concentrations to roll off, we have started initiatives to diversify the Bank’s lending portfolio and change our lending culture. The mortgage and consumer lending operations have maintained strong credit quality metrics through this recession. These areas are being restructured to allow for additional emphasis on retail lending going forward. We will also emphasize small business lending and will seek resources to add expertise in this area. Our efforts will focus on back to basic community banking and servicing the entire relationship of the customer. These loans will be used to diversify the loan portfolio of the Bank as well as provide for profitability as the Bank works through our credit quality issues.