Note 2.

Regulatory Matters and Significant Risks or Uncertainties

FDIC and Department of Banking Memorandum of Understanding

On July 15, 2009, Royal Bank agreed to enter into a Stipulation and Consent to the Issuance of an Order to Cease and Desist (the “Orders”) with each of the Federal Deposit Insurance Corporation (“FDIC”) and the Pennsylvania Department of Banking (the “Department”). The material terms of the Orders were identical and required Royal Bank among other items to maintain, after establishing an adequate allowance for loan and lease losses, a ratio of Tier 1 capital to total assets (“leverage ratio”) equal to or greater than 8% and a ratio of qualifying total capital to risk-weighted assets (“total risk-based capital ratio”) equal to or greater than 12%. The FDIC and the Department replaced the Orders in the fourth quarter of 2011 with an informal agreement, known as a memorandum of understanding (“MOU”). Included in the MOU is the continued requirement of maintaining a leverage ratio equal to or greater than 8% and a total risk-based capital ratio equal to or greater than 12%. At June 30, 2013, based on capital levels calculated under regulatory accounting principles (“RAP”), Royal Bank’s Tier 1 leverage and total risk-based capital ratios were 9.09% and 15.45%, respectively. Please refer to “Note 11 – Regulatory Capital Requirements” to the consolidated financial statements.

Following the issuance of the Orders, management implemented plans to address key areas that were noted in the Orders. Management has reduced classified assets, delinquencies, commercial real estate concentrations, reliance on non-core deposits and wholesale funding sources and maintained capital ratios above required minimums which were all factors that contributed to replacing the Orders with the MOU. Management has continued to improve in each of these areas since the Orders were replaced with the MOU.

Federal Reserve Memorandum of Understanding

As previously disclosed, in March 2010, the Company agreed to enter into a written agreement (the “Federal Reserve Agreement”) with the Federal Reserve Bank of Philadelphia (the “Federal Reserve Bank”). In July 2013, the Board of Governors of the Federal Reserve System terminated the enforcement action under Federal Reserve Agreement, and it was replaced with an informal agreement, an MOU, with the Federal Reserve Bank, effective July 17, 2013. Included in the MOU are certain continued reporting requirements and a requirement that the Company receive the prior approval of the Federal Reserve Bank prior to declaring or paying any dividends on the Company’s common stock, making interest payments related to the Company’s outstanding trust preferred securities or subordinate securities, incurring or guaranteeing certain debt with an original maturity date greater than one year, and purchasing or redeeming any shares of stock. The MOU will remain in effect until stayed, modified, terminated or suspended in writing by the Federal Reserve Bank.

Our success as a Company is dependent upon pursuing various alternatives in not only achieving the growth and expansion of our banking franchise but also in managing our day to day operations. The existence of the two MOUs may limit or impact our ability to pursue all previously available alternatives in the management of the Company. Our ability to retain existing retail and commercial customers as well as the ability to attract potentially new customers may be impacted by the existence of the MOUs. Additionally, the Company’s ability to raise capital in the current economic environment could be potentially limited or impacted as a result of the MOUs. Attracting new management talent is critical to the success of our business and could be potentially effected due to the existence of the MOUs.

Significant Losses

For the period 2008 through 2012, the Company has recorded significant losses totaling $119.6 million which were primarily related to charge-offs on the loan and lease portfolio, impairment charges on investment securities, impairment charges on other real estate owned (“OREO”), credit related expenses and the establishment of a deferred tax valuation allowance. For the second quarter of 2013, the Company recorded a net loss of $803,000 compared to a net loss of $2.0 million for the comparable period in 2012. The quarter over quarter decline in net loss was mainly related to a $1.7 million decline in provision for loan and lease losses, a $943,000 decrease in credit related expenses and an $859,000 decline in other-than-temporary impairment on investment securities. Partially offsetting these items was a $1.65 million loss contingency accrual for a settlement of the class action lawsuit related to the tax lien subsidiaries. After adjusting for the noncontrolling interest, the Company’s 60% share of the loss contingency amounted to $990,000 on a pre-tax basis. Additionally for the second quarter of 2013 net interest income declined $960,000 from the comparable quarter in 2012. For the six months ended June 30, 2013, the Company recorded a net loss of $685,000 compared to a net loss of $2.8 million for the same period in 2012. The decline in net loss was mainly related to a $2.0 million decline in provision for loan and lease losses and a $1.1 million decrease in credit related expenses and an $842,000 decline in professional and legal fees. Partially offsetting these items was a decrease in net interest income of $2.2 million. In addition to reducing the total shareholders’ equity, the continued losses and negative retained earnings impacts the Company’s ability to pay cash dividends to its shareholders now and in future years. The Company’s deferred tax valuation allowance amounted to $39.6 million at June 30, 2013. The deferred tax valuation allowance is a result of management’s conclusion that it was more likely than not that the Company would not generate sufficient future taxable income to realize all of the deferred tax asset which equaled $41.5 million at June 30, 2013.

Credit Quality

Adverse economic conditions in our specific market areas and decreases in real estate property values due to the nature of our loan portfolio in particular have affected the ability of customers to repay their loans and generally impact our financial condition and results of operations. The financial services and real estate industries were hit particularly hard during the “Great Recession” and as a result the Company’s loan and investment portfolios were directly affected. The Company’s commercial real estate loans, including construction and land development loans, have seen a decline in the collateral values, and a reduction in the borrowers’ ability to meet the payment terms of their loans due to reduced cash flow. Further declines in collateral values and borrowers’ liquidity with sustained unemployment at current levels may lead to additional increases in foreclosures, delinquencies and customer bankruptcies. The Company is less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of more diverse economies.

The Company had non-performing loans of $17.8 million and $23.0 million at June 30, 2013 and December 31, 2012, respectively. The Company recorded $311,000 and $2.4 million in charge-offs and write-downs for the three and six months ended June 30, 2013, respectively compared to $628,000 and $781,000 in charge-offs and write-downs for the comparable periods of 2012, respectively. OREO balances were $13.0 million at June 30, 2013 and $13.4 million at December 31, 2012.

Royal Bank was successful in reducing net classified loans, which includes LHFS and OREO from $51.8 million at December 31, 2012 to $45.6 million at June 30, 2013. Royal Bank’s delinquent loans held for investment (30 to 90 days) amounted to $1.3 million at June 30, 2013 versus $4.6 million at December 31, 2012. Material advances on any classified or delinquent loan are to be approved by the Board of Directors and determined to be in Royal Bank’s best interest. The Company has restructured the investment portfolio to reduce credit risk by selling corporate debt securities and equity securities and replacing their maturities with U.S. government issued or sponsored securities. Royal Bank recorded $859,000 in other-than-temporary-impairment (“OTTI”) losses during the six months ended June 30, 2012 compared to $0 for the comparable period in 2013.

Commercial Real Estate Concentrations

As mentioned previously the adverse economic conditions have primarily impacted the real estate secured loan portfolio. Commercial real estate and construction and development loans are often riskier and tend to have significantly larger balances than home equity loans or residential mortgage loans to individuals. While the Company believes that the commercial real estate concentration risk is mitigated by diversification among the types and characteristics of real estate collateral properties, sound underwriting practices, and ongoing portfolio monitoring and market analysis, the repayments of these loans usually depends on the profitable operation of a business or the sale of the underlying property. As a result, these loans are more likely to be unfavorably affected by adverse conditions in the real estate market or the economy in general, which may result in increasing levels of loan charge-offs and non-performing assets and the reduction of earnings. When we take collateral in foreclosures and similar proceedings, we are required to mark the related asset to the then fair market value of the collateral, which may ultimately result in a loss. It is possible that Royal Bank may be required to maintain higher levels of capital than it would be otherwise be expected to maintain as a result of the Bank’s commercial real estate loans, which may require the Company to obtain additional capital.

Commercial real estate, multi-family and construction and land development loans held for investment were $227.0 million at June 30, 2013 comprising 62% of total loans compared to $216.1 million at December 31, 2012 comprising 63% of total loans. Based on capital levels calculated under U.S. GAAP and RAP, Royal Bank does not have a concentration of commercial real estate loans as defined in the joint agency “Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices” issued on December 12, 2006. Please see discussion in “Note 11 – Regulatory Capital Requirements” to the consolidated financial statements.

Liquidity and Funds Management

Royal Bank has limited capacity to borrow additional funds in the event it is needed for liquidity purposes. However, Royal Bank has continued to maintain liquidity measures that are well in excess of the target levels. As discussed in “Note 8 – Borrowings and Subordinated Debentures” to the consolidated financial statements, Royal Bank has an over collateralized delivery requirement of 105% with the FHLB as a result of the level of non-performing assets and the losses that have been experienced over the past five years. The ability to borrow additional funds is based on the amount of collateral that is available to be pledged. As of June 30, 2013, Royal Bank had $21.5 million of available borrowing capacity at the FHLB as a result of excess collateral that has been pledged. In addition at June 30, 2013, Royal Bank had $164.6 million in unpledged agency securities that were available to be pledged as collateral if needed and $23.5 million in cash on hand. Royal Bank also has limited availability to borrow from the Federal Reserve Discount Window, which was $7.9 million at June 30, 2013, and was based on collateral pledged.

At June 30, 2013, the liquidity to deposits ratio was 42.6% compared to Royal Bank’s 12% policy target and the liquidity to total liabilities ratio was 32.8% compared to Royal Bank’s 10% policy target. Borrowings were $108.1 million and $108.3 million at June 30, 2013and December 31, 2012, respectively.

The Company also has unfunded pension plan obligations, which potentially could impact liquidity, of $16.7 million as of June 30, 2013 compared to $16.9 million at December 31, 2012. The Company plans to fund the pension plan obligations through existing Company owned life insurance policies.

Dividend and Interest Restrictions

Due to the MOU, our ability to obtain lines of credit, to receive attractive collateral treatment from funding sources, and to pursue all attractive funding alternatives in this current low interest rate environment could be impacted and thereby limit liquidity alternatives. On August 13, 2009, the Company’s Board of Directors determined to suspend regular quarterly cash dividends on the $30.4 million in Series A Preferred Stock and to suspend interest payments on the $25.8 million in trust preferred securities. As of June 30, 2013, the Series A Preferred stock dividend in arrears was $6.8 million and has not been recognized in the consolidated financial statements. In the event the Company declared the preferred dividend the Company’s capital ratios would be negatively affected; however, they would remain above the required minimum ratios. Please read “Note 11 - Regulatory Capital Requirements” to the consolidated financial statements. As of June 30, 2013 the trust preferred interest payment in arrears was $2.8 million and has been recorded in interest expense and accrued interest payable. The Company believes the decision to suspend the preferred cash dividends and the trust preferred interest payments will better support the liquidity position of Royal Bank. The interest payment deferral period on the trust preferred securities ends after the second quarter of 2014. After the ending of the deferral period if the interest payments are not made then it would constitute an event of default which could impact the Company’s consolidated financial statements and liquidity.

At June 30, 2013, as a result of significant losses within Royal Bank, the Company had negative retained earnings and therefore would not have been able to declare and pay any cash dividends. Royal Bank must receive prior approval from the FDIC and the Department before declaring and paying a dividend to the Company. Under the Federal Reserve MOU the Company may not declare or pay any dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.

Capital Adequacy

In connection with a prior bank regulatory examination, the FDIC concluded, based upon its interpretation of the Consolidated Reports of Condition and Income (the “Call Report”) instructions and under RAP, that income from Royal Bank’s tax lien business should be recognized on a cash basis, not an accrual basis. Royal Bank’s current accrual method is in accordance with U.S. GAAP. Royal Bank disagrees with the FDIC’s conclusion and filed the Call Report for June 30, 2013 and the previous eleven quarters in accordance with U.S. GAAP. However, the change in the manner of revenue recognition for the tax lien business for regulatory accounting purposes affects Royal Bank’s and potentially the Company’s capital ratios as disclosed in “Note 11 - Regulatory Capital Requirements” to the consolidated financial statements. Royal Bank is in discussions with the FDIC to resolve the matter.

Under the FDIC MOU, Royal Bank must maintain a minimum total risk-based capital ratio and a minimum Tier 1 leverage ratio of 12% and 8%, respectively. At June 30, 2013, based on capital levels calculated under RAP, Royal Bank’s Tier 1 leverage and total risk-based capital ratios were 9.09% and 15.45%, respectively.

Department of Justice Investigation (“DOJ”)

Royal Bank holds a 60% equity interest in each of CSC and RTL. The Company acquired its ownership interest in CSC in 2001. CSC and RTL acquired, through public auction, delinquent tax liens in various jurisdictions thereby assuming a superior lien position to most other lien holders, including mortgage lien holders. On March 4, 2009, each of CSC and RTL received grand jury subpoenas issued by the U.S. District Court for New Jersey (“Court”) upon application of the Antitrust Division of the United States DOJ. The subpoenas sought certain documents and information relating to an ongoing investigation being conducted by the DOJ relating to alleged bid-rigging at tax lien auctions in New Jersey. On February 23, 2012, the former President of CSC and RTL entered a plea of guilty to one count of conspiring to rig bids at certain auctions for tax liens in New Jersey from 1998 until approximately the spring of 2009. The former President’s employment with CSC and RTL was terminated in November 2010. Based on discussions with the DOJ and the plea entered by the former President of CSC and RTL, the Company believed that the outcome of the investigation would result in fines and penalties being assessed against CSC, RTL or both. As a result, the Company accrued $2.0 million during 2012 for a DOJ fine relating to the DOJ investigation. After adjusting for the noncontrolling interest, the Company’s 60% share of the fine amounted to $1.2 million. On September 26, 2012, as a result of the former President’s guilty plea and pursuant to a plea agreement with the DOJ, CSC entered a guilty plea in the United States District Court for the District of New Jersey to one count of conspiracy to commit bid-rigging at certain auctions for tax liens in New Jersey. Under the terms of the plea agreement, which the Court accepted at the September 26, 2012 plea hearing, the DOJ agreed not to bring further criminal charges against CSC and not to bring criminal charges against RTL, or any current or former director, officer, or employee of CSC and/or RTL, for any act or offense committed prior to the date of the plea agreement that was in furtherance of any agreement to rig bids at municipal tax lien sales or auctions in the State of New Jersey. The former President of CSC and RTL and any person who bid at any time at a tax lien auction on behalf of CSC and/or RTL are excluded from this non-prosecution protection. At the sentencing hearing held in December 2012, the sentencing judge agreed with the DOJ’s recommendation and imposed a $2.0 million fine for CSC, which, as stated above, had been previously recognized in the Company’s consolidated financial statements. The Company is evaluating appropriate legal action against the former President of CSC and RTL to attempt to recover legal expenses and any fines or penalties ultimately levied against CSC.

Additionally a number of lawsuits have been filed in the Superior Court of New Jersey against the former President of CSC and RTL, CSC, RTL, Royal Bancshares of Pennsylvania and certain other parties on behalf of a proposed class of taxpayers who became delinquent in paying their municipal tax obligations. These lawsuits allege violations of the New Jersey Antitrust Act and unjust enrichment, and seek treble damages, attorney fees and injunctive relief. CSC, RTL and Royal Bancshares removed these cases to the U.S. District Court for the District of New Jersey. On June 12, 2012, the Court entered an Order consolidating for pretrial purposes the above actions with all subsequently filed or transferred related actions, collectively referred to as In re New Jersey Tax Sale Certificates Antitrust Litigation. On October 22, 2012, the Court appointed two law firms as interim class counsel and another law firm as liaison class counsel and further ordered appointed counsel to file a master complaint for the consolidated action. On December 21, 2012, plaintiffs filed a Consolidated Master Class Action Complaint (the “Complaint”) against numerous defendants, including the former President of CSC and RTL, Royal Bancshares of Pennsylvania, Inc., Royal Bank America, CSC and RTL. The Company filed a motion to dismiss the Complaint on March 8, 2013, which is currently pending before the Court. During the second quarter of 2013, the Company accrued a loss contingency of $1.65 million for a potential settlement with the plaintiffs. After adjusting for the noncontrolling interest, the Company’s 60% share of the loss contingency amounted to $990,000. Subsequently, Royal Bancshares of Pennsylvania, Inc., Royal Bank America, CSC, and RTL reached an agreement in principle with plaintiffs to settle the litigation for $1.65 million and other terms and conditions, including an opportunity for members of the proposed settlement class whose tax liens are currently held by CSC or RTL to redeem those liens for a one-time cash payment equaling 85% of the redemption amount by making such payment within 35 days of the date of written notice. The proposed settlement class does not include, and therefore the offer to redeem does not apply to, tax liens acquired at 0% interest or at a premium. The settlement is contingent upon negotiation of a definitive settlement agreement and is subject to Court approval after notice and a hearing. Members of the proposed settlement class will have an opportunity to object to the proposed settlement or opt-out.

Company Plans and Strategy

The Company has enhanced the Board through the addition of experienced directors with diverse backgrounds. The newer members are comprised of the following: a former banking regulator with consulting experience, a former Chief Executive Officer (“CEO”) of a much larger financial institution who has bank turnaround experience, a former President of the lead bank within a larger financial institution (Treasury appointee), a former executive within the financial services industry (Treasury appointee) and a former senior partner of a public accounting firm. During the first quarter of 2012, the Board elected a Lead Independent Director to further improve corporate governance by serving as a liaison between the Chairman of the Board, management, and the independent directors. During 2012, Royal Bank hired a new Chief Lending Officer (“CLO”) who has significant experience in commercial and consumer lending with a larger bank within the Philadelphia market. On December 18, 2012 the Company announced F. Kevin Tylus as President and CEO of Royal Bank. On February 20, 2013, the Company announced that Mr. Tylus was appointed President, CEO and a Class III member of the Board of Directors of the Company. Former CEO, Robert Tabas, remains as Chairman of the Board of Directors.

In order to meet the requirements in the previous Orders, the previous Federal Reserve Agreement, and the current MOUs, management adopted a strategy to deleverage the balance sheet in order to maintain capital ratios at required regulatory minimums. The Board and management remain committed to meeting the capital level requirements for Royal Bank as set forth in the FDIC MOU. As a result, the Board and management have developed a contingency plan to maintain capital ratios at required levels which may include selling interest-earning assets. This strategy also assisted in reducing the level of classified assets by giving management the ability to actively pursue exit strategies on loans and OREO which were at historically high levels. The deleveraging was largely accomplished by the continued reduction of brokered deposits from $89.1 million at December 31, 2010 to $0 as of June 30, 2013. In addition, borrowings were reduced by $46.8 million during the same period. The Company’s strategic plan includes improving the overall level of credit quality, maintaining reduced credit risk within the investment portfolio, reducing the overall level of expenses, and returning to profitability.

During the past few years, the Company recorded significant impairment charges and carrying costs on non-accrual loans and OREO which has weighed heavily on earnings and was the largest contributing factor to the Company’s losses. While sustaining capital ratios above the required minimum, the Company has made progress in improving credit quality, reducing the CRE concentration, strengthening the Board and maintaining liquidity. As a result of the decline in level of classified assets, there has been a corresponding reduction in the provision for loan and lease losses and the overall carrying costs associated with classified assets. The deleveraging of the balance sheet has also reduced earning assets which has resulted in a decline in net interest income and has had a significant impact on overall earnings. To improve net interest margin and net interest income, management is diligently working on changing the mix of earnings assets and interest-bearing liabilities. In the event further deleveraging is necessary to maintain the required capital levels, net interest income would be negatively impacted.

The Company is focused on transitioning Royal Bank into a more traditional community bank with the branches becoming selling centers and not just service centers. Traditional consumer products such as home equity loans and a new mobile banking application are part of the expanded product offerings. Recently the Company launched a new website, which takes advantage of the latest technologies and trends in web development, including responsive design which reformats content to fit any screen, improving both aesthetics and user experience. Visitors will also find a renewed emphasis on our most important products and services, including quick links to key revenue driving product lines, our newly launched secure home equity application and our powerful online and mobile banking tools. With the recent retirement of Royal Bank’s Senior Vice President of Branch Administration, the Company has launched an executive search for a retail executive with prior experience in expanding retail sales capabilities, refreshing the branch footprint and achieving further penetration of its recently-expanded retail and web-based products.

The Company has developed a management Profitability Improvement Plan (the “Plan”) to generate steady revenue growth, expense management and gain operational efficiencies. Specific initiatives of the Plan effectuated in the first two quarters of 2013 focused on adjustments to personnel of the Company and discretionary expenses. These efforts, which included a 9% reduction in workforce and an annualized reduction of approximately 10% of discretionary expenses, were implemented and enhanced day-to-day operations and the ability of the Company to drive new revenue. The Company has reorganized and relocated certain personnel to improve departmental synergies and better align managers and staff so they can work together in cohesive teams to accomplish these objectives. Additionally, the Company is currently developing a facilities rationalization plan as part of the overall strategic goal to return to profitability. During the first quarter of 2013, the Company sold its storage facility site in Philadelphia and a building in Narberth that housed the training center. The Company recorded gains of $676,000 as a result of these sales. In January 2013, Royal Bank consolidated the leased Henderson Road office between the King of Prussia and Bridgeport offices and retained the majority of the deposits. Additionally, in April 2013, to achieve operational efficiencies, the tax lien subsidiaries relocated from their leased office space in Jenkintown, Pennsylvania to the corporate location in Narberth. As a result of the reduction in workforce and the vacating of leased real estate, the Company recorded $111,000 in restructuring charges directly related to one-time employee termination benefits and an effective termination of a lease. During the third quarter of 2013, the Company will consolidate the 15^th Street branch office into the Walnut Street branch office, which are both located in Center City Philadelphia. The Company continues to review its retail footprint and will explore additional branch office relocations, consolidations or both. The Company also is implementing a unique opportunity to reduce employee expenses as certain individuals will become employees of a local company who in turn will provide servicing of the remaining tax lien and non-performing assets portfolios. Those portfolios continue to diminish per the Company's strategic plan. This outsourcing arrangement allows the Company to focus on the expansion of its core banking products while de-emphasizing legacy non-core activity such as tax liens. The Company has targeted to have the Plan fully implemented by the end of 2013. Through the reorganizing of the Lending and Credit departments during the last half of 2012, Royal Bank was able to increase LHFI $23.7 million from $344.2 million at December 31, 2012 to $367.9 million at June 30, 2013. All of these plans are focused on repositioning the Company for 2013 and beyond.