UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-K





x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934





For the Fiscal Year Ended December 31, 2010




or





o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934





Commission File Number 0-14412





Farmers Capital Bank Corporation(Exact name of registrant as specified in its charter)





Kentucky

61-1017851(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification Number)





P.O. Box 309, 202 West Main St.Frankfort, Kentucky

40601(Address of principal executive offices)

(Zip Code)





Registrant's telephone number, including area code: (502) 227-1600





Securities registered pursuant to Section 12(b) of the Act:





Common Stock - $.125 per share Par Value

The NASDAQ Global Select Market(Title of each class)

(Name of each exchange on which registered)





Securities registered pursuant to Section 12(g) of the Act:





None(Title of Class)





Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.





Yes o
No x





Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.





Yes o
No x





Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.





Yes x
No o





Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.o




8




Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.





Large accelerated filer o

Accelerated filer oNon-accelerated filer x

Smaller reporting company o





Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act)





Yes o
No x





The aggregate market value of the registrant’s outstanding voting stock held by non-affiliates on June 30, 2010 (the last business day of the registrant’s most recently completed second fiscal quarter) was $33.5 million based on the closing price per share of the registrant’s common stock reported on the NASDAQ.





As of March 7, 2011 there were 7,411,676 shares of common stock outstanding.





Documents incorporated by reference:





Portions of the Registrant’s Proxy Statement relating to the Registrant’s 2011 Annual Meeting of Shareholders are incorporated by reference into Part III.





An index of exhibits filed with this Form 10-K can be found on page 123.




9




FARMERS CAPITAL BANK CORPORATION


FORM 10-K


INDEX





PagePart IItem 1.
Business
11Item 1A.
Risk Factors
27Item 1B.
Unresolved Staff Comments
37Item 2.
Properties
37Item 3.
Legal Proceedings
38Item 4.
Submission of Matters to a Vote of Security Holders
38Part IIItem 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
38Item 6.
Selected Financial Data
41Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations
42Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
74Item 8.
Financial Statements and Supplementary Data
75Item 9.
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
118Item 9A.
Controls and Procedures
118Item 9B.
Other Information
119Part IIIItem 10.
Directors, Executive Officers and Corporate Governance
119Item 11.
Executive Compensation
119Item 12.
Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters
119Item 13.
Certain Relationships and Related Transactions
119Item 14.
Principal Accounting Fees and Services
119Part IVItem 15.
Exhibits, Financial Statement Schedules
120Signatures
122Index of Exhibits
123




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PART I





Item 1. Business





The disclosures set forth in this item are qualified by Item 1A (“Risk Factors”) beginning on page 27 and the section captioned “Forward-Looking Statements” in Item 7 (“Management’s Discussion and Analysis of Financial Condition and Results of Operations”) beginning on page 42 of this report and other cautionary statements contain elsewhere in this report.





Organization


Farmers Capital Bank Corporation (the “Registrant”, “Company”, “we”, “us”, or “Parent Company”) is a bank holding company with four bank subsidiaries.  The Registrant was originally formed as a bank holding company under the Bank Holding Company Act of 1956, as amended, on October 28, 1982 under the laws of the Commonwealth of Kentucky.  During 2000, the Federal Reserve Board granted the Company financial holding company status. The Company withdrew its financial holding company election subsequent to the sale KHL Holdings, LLC (“KHL Holdings”) during the third quarter of 2009. The Company’s subsidiaries provide a wide range of banking and bank-related services to customers throughout Central and Northern Kentucky.  The four bank subsidiaries owned by the Company include Farmers Bank & Capital Trust Company ("Farmers Bank"), Frankfort, Kentucky; United Bank & Trust Company ("United Bank"), Versailles, Kentucky; First Citizens Bank (“First Citizens”), Elizabethtown, Kentucky; and Citizens Bank of Northern Kentucky, Inc. (“Citizens Northern”), Newport, Kentucky. The Lawrenceburg Bank and Trust Company ("Lawrenceburg Bank"), Lawrenceburg, Kentucky, which previously was a separate bank subsidiary of the Parent Company, was merged into Farmers Bank during the second quarter of 2010.





The Company also owns FCB Services, Inc., ("FCB Services"), a nonbank data processing subsidiary located in Frankfort, Kentucky; FFKT Insurance Services, Inc., (“FFKT Insurance”), a captive property and casualty insurance company in Frankfort, Kentucky; EKT Properties, Inc., established during 2008 to manage and liquidate certain real estate properties repossessed by the Company; and Farmers Capital Bank Trust I (“Trust I”), Farmers Capital Bank Trust II (“Trust II”), and Farmers Capital Bank Trust III (“Trust III”), which are unconsolidated trusts established to complete the private offering of trust preferred securities. In the case of Trust I and Trust II, the proceeds of the offerings were used to finance the cash portion of the acquisition in 2005 of Citizens Bancorp Inc. (“Citizens Bancorp”), the former parent company of Citizens Northern. For Trust III, the proceeds of the offering were used to finance the cost of acquiring Company shares under a share repurchase program during 2007.





Kentucky General Holdings, LLC, (“Kentucky General”), in Frankfort, Kentucky, was a nonbank subsidiary of the Parent Company until it was dissolved during the third quarter of 2010. During 2009 Kentucky General sold its entire interest in KHL Holdings, the parent company of Kentucky Home Life Insurance Company (“KHL Insurance”).





The Company provides a broad range of financial services at its 36 locations in 23 communities throughout Central and Northern Kentucky to individual, business, agriculture, government, and educational customers. Its primary deposit products are checking, savings, and term certificate accounts.  Its primary lending products are residential mortgage, commercial lending, and consumer installment loans. Substantially all loans and leases are secured by specific items of collateral including business assets, consumer assets, and commercial and residential real estate. Commercial loans and leases are expected to be repaid from cash flow from operations of businesses. Farmers Bank has served as the general depository for the Commonwealth of Kentucky for over 70 years and also provides investment and other services to the Commonwealth. Other services provided by the Company include, but are not limited to, cash management services, issuing letters of credit, safe deposit box rental, and providing funds transfer services.  Other financial instruments, which potentially represent concentrations of credit risk, include deposit accounts in other financial institutions and federal funds sold.





While the chief decision-makers monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis.   Operating segments are aggregated into one as operating results for all segments are similar. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable segment.  As of December 31, 2010, the Company had $1.9 billion in consolidated assets.





11





Organization Chart


Subsidiaries of Farmers Capital Bank Corporation at December 31, 2010 are indicated in the table that follows. Percentages reflect the ownership interest held by the parent company of each of the subsidiaries. Tier 2 subsidiaries are direct subsidiaries of Farmers Capital Bank Corporation. Tier 3 subsidiaries are direct subsidiaries of the Tier 2 subsidiary listed immediately above them. Tier 4 subsidiaries are direct subsidiaries of the Tier 3 subsidiary listed immediately above them. Tier 5 subsidiaries are direct subsidiaries of the Tier 4 subsidiary listed immediately above them.





Tier
Entity1
Farmers Capital Bank Corporation, Frankfort, KY (Parent Company)2

United Bank & Trust Company, Versailles, KY 100%3


EGT Properties, Inc., Georgetown, KY 100%4



NUBT Properties, LLC, Georgetown, KY 83%5



Flowing Creek Realty, LLC, Bloomfield, IN 67%2

Farmers Bank & Capital Trust Company, Frankfort, KY 100%3


Farmers Bank Realty Co., Frankfort, KY 100%3


Leasing One Corporation, Frankfort, KY 100%3


EG Properties, Inc., Frankfort, KY 100%3


FA Properties, Inc., Frankfort, KY 100%3


FORE Realty, LLC, Frankfort, KY 100%3


LORE Realty, LLC, Frankfort, KY 100%3


Austin Park Apartments, LTD, Frankfort, KY 99%3


Frankfort Apartments II, LTD, Frankfort, KY 99.9%3


St. Clair Properties, LLC, Frankfort, KY 95%3


Farmers Capital Insurance Corporation, Frankfort, KY 100%4



Farmers Fidelity Insurance Agency, LLP, Lexington, KY 50%2

First Citizens Bank, Elizabethtown, KY 100%2

Citizens Bank of Northern Kentucky, Inc., Newport, KY 100%3


ENKY Properties, Inc., Newport, KY 100%4



NUBT Properties, LLC, Georgetown, KY 17%5



Flowing Creek Realty, LLC, Bloomfield, IN 67%2

FCB Services, Inc., Frankfort, KY 100%2

FFKT Insurance Services, Inc., Frankfort, KY 100%2

Farmers Capital Bank Trust I, Frankfort, KY 100%2

Farmers Capital Bank Trust II, Frankfort, KY 100%2

Farmers Capital Bank Trust III, Frankfort, KY 100%2

EKT Properties, Inc. Frankfort, KY 100%





Farmers Bank and Subsidiaries


Farmers Bank, originally organized in 1850, is a state chartered bank engaged in a wide range of commercial and personal banking activities, which include accepting savings, time and demand deposits; making secured and unsecured loans to corporations, individuals and others; providing cash management services to corporate and individual customers; issuing letters of credit; renting safe deposit boxes; and providing funds transfer services.  The bank's lending activities include making commercial, construction, mortgage, and personal loans and lines of credit.  The bank serves as an agent in providing credit card loans.  It acts as trustee of personal trusts, as executor of estates, as trustee for employee benefit trusts and as registrar, transfer agent and paying agent for bond issues.  Farmers Bank is the general depository for the Commonwealth of Kentucky and has been for more than 70 years.




12





Farmers Bank is the largest bank operating in Franklin County based on total bank deposits in the county.  It conducts business at its principal office and four branches in Frankfort, the capital of Kentucky, as well as two branches in Anderson County, Kentucky, and one branch each in Mercer County, Kentucky and Boyle County, Kentucky.  The market served by Farmers Bank is diverse, and includes government, commerce, finance, industry, medicine, education and agriculture.  The bank serves many individuals and corporations throughout Central Kentucky.  On December 31, 2010, it had total consolidated assets of $750 million, including loans net of unearned income of $422 million.  On the same date, total deposits were $570 million and shareholders' equity totaled $67.2 million.





On October 23, 2009, the Company announced that it was in the preliminary stages of merging Lawrenceburg Bank into Farmers Bank.  The Company applied for regulatory approval for the merger in the first quarter of 2010 and the merger was effective during the second quarter of 2010.





Farmers Bank had ten active subsidiaries during 2010:  Farmers Bank Realty Co. ("Farmers Realty"), Leasing One Corporation ("Leasing One"), Farmers Capital Insurance Corporation (“Farmers Insurance”), EG Properties, Inc. (“EG Properties”), FA Properties, Inc. (“FA Properties”), FORE Realty, LLC (“FORE Realty”), LORE Realty, LLC (“LORE Realty”), St. Clair Properties, LLC (“St. Clair Properties”), Austin Park Apartments, LTD (“Austin Park”), and Frankfort Apartments II, LTD (“Frankfort Apartments”).





Farmers Realty was incorporated in 1978 for the purpose of owning certain real estate used by the Company and Farmers Bank in the ordinary course of business.  Farmers Realty had total assets of $3.8 million on December 31, 2010.





Leasing One was incorporated in August 1993 to operate as a commercial equipment leasing company.  It is located in Frankfort and is licensed to conduct business in twelve states.  At year-end 2010, it had total assets of $14.7 million, including leases net of unearned income of $7.8 million. The board of directors of Leasing One has reduced the staff and curtailed new lending for the present time.  Servicing existing leases and terming out residuals are the extent of its ongoing activity at the present time.





Farmers Insurance was organized in 1988 to engage in insurance activities permitted to the Company under federal and state law.  Farmers Bank capitalized this corporation in December 1998.   Farmers Insurance acts as an agent for Stewart Title Guaranty Company.  At year-end 2010 it had total assets of $241 thousand.  Farmers Insurance holds a 50% interest in Farmers Fidelity Insurance Company, LLP (“Farmers Fidelity”).  The Creech & Stafford Insurance Agency, Inc., an otherwise unrelated party to the Company, also holds a 50% interest in Farmers Fidelity. Farmers Fidelity is a direct writer of property and casualty coverage, both individual and commercial.





In November 2002 Farmers Bank incorporated EG Properties.  EG Properties is involved in real estate management and liquidation for certain properties repossessed by Farmers Bank.  It had total assets of $6.2 million at December 31, 2010.





In July 2008, Farmers Bank incorporated FA Properties, which owns automobiles that are used by the Company and Farmers Bank in the ordinary course of business. It had total assets of $380 thousand at year-end 2010. FORE Realty and LORE Realty were organized in December 2009 and February 2010, respectively, for the purpose of managing and liquidating certain other properties repossessed by Farmers Bank. At year-end 2010 FORE Realty had total assets of $67 thousand; LORE Realty was dissolved effective January 1, 2011.





Farmers Bank is a limited partner in Austin Park and Frankfort Apartments, two low income housing tax credit partnerships located in Frankfort, Kentucky.  These investments provide for federal income tax credits to the Company.  Farmers Bank’s aggregate investment in these partnerships was $417 thousand at year-end 2010. In December 2009 Farmers Bank became a limited partner in St. Clair Properties. The objective of St. Clair Properties is to restore and preserve certain qualifying historic structures in Frankfort for which the Company receives federal and state tax credits. Farmers Bank’s investment in St. Clair Properties was less than $10 thousand at year-end 2010.





Lawrenceburg Bank


On June 28, 1985, the Company acquired Lawrenceburg Bank, a state chartered bank originally organized in 1885 in Anderson County. As mentioned above, Lawrenceburg Bank was merged into Farmers Bank during the second quarter of 2010. Based on deposits at its Anderson County locations, Farmers Bank has the largest market presence in Anderson County.





United Bank and Subsidiary


On February 15, 1985, the Company acquired United Bank, a state chartered bank originally organized in 1880.  It is engaged in a general banking business providing full service banking to individuals, businesses and governmental customers.  On November 1, 2008, the Company merged Farmers Bank & Trust Company (“Farmers Georgetown”) and Citizens Bank of Jessamine County (“Citizens Jessamine”) into United Bank. Each of these three banks was previously a wholly-owned subsidiary of the Company. United Bank conducts business in its principal office and two branches in Woodford County, Kentucky, four branches in Scott County, Kentucky, three branches in Fayette County, Kentucky, and four branches in Jessamine County, Kentucky.  Based on total bank deposits in Woodford County, United Bank is the second largest bank operating in Woodford County with total consolidated assets of $614 million and total deposits of $448 million at December 31, 2010.




13





United Bank had one subsidiary during 2010, EGT Properties, Inc. EGT Properties was created in March 2008 and is involved in real estate management and liquidation for certain repossessed properties of United Bank.  In addition, EGT Properties holds an 83% interest in NUBT Properties, LLC (“NUBT”), the parent company of Flowing Creek Realty, LLC (“Flowing Creek”). Flowing Creek holds real estate that has been repossessed by United Bank and Citizens Northern along with parties unrelated to the Company. NUBT holds a 67% interest in Flowing Creek and unrelated financial institutions hold the remaining 33% interest. EGT Properties had total assets of $22.0 million at year-end 2010.





Prior to 2009, United Bank operated EV Properties, Inc. (“EV Properties”). EV Properties was involved in real estate management and liquidation for certain properties repossessed by United Bank. EV Properties was dissolved on December 31, 2008.





Farmers Georgetown


On June 30, 1986, the Company acquired Farmers Georgetown, a state chartered bank originally organized in 1850 located in Scott County, Kentucky. On November 1, 2008, the Company merged Farmers Georgetown into United Bank. Based on deposits at its Scott County locations, United Bank has the largest market presence in Scott County.





Citizens Jessamine


On October 1, 2006, the Company acquired Citizens National Bancshares (“Citizens Bancshares”), the former one-bank holding company of Citizens Jessamine. Citizens Bancshares was subsequently merged into the Company, leaving Citizens Jessamine as a direct subsidiary of the Company. Citizens Jessamine, organized in 1996 as a national charter bank located in Jessamine County, Kentucky, was merged into United Bank on November 1, 2008.  Based on deposits at its Jessamine County locations, United Bank has the largest market presence in Jessamine County.





First Citizens


On March 31, 1986, the Company acquired First Citizens, a state chartered bank originally organized in 1964.  It is engaged in a general banking business providing full service banking to individuals, businesses and governmental customers. It conducts business at its main office and three branches in Hardin County, Kentucky along with two branch offices in Bullitt County, Kentucky.  During 2003 First Citizens incorporated EH Properties, Inc.  This company was involved in real estate management and liquidation for certain properties repossessed by First Citizens prior to it being dissolved in January, 2007.





On October 8, 2004, First Citizens acquired Financial National Electronic Transfer, Inc. (“FiNET”), a data processing company that specializes in the processing of federal benefit payments and military allotments, headquartered in Radcliff, Kentucky.  Effective January 1, 2005 FiNET was merged into First Citizens. These services are now operated using the name of FirstNet.





On November 2, 2006, First Citizens announced the signing of a definitive agreement to acquire the military allotment operation of PNC Bank, National Association based in Elizabethtown, Kentucky. The operation specializes in the processing of data associated with military allotments and federal benefit payments. The transaction was completed on January 12, 2007 and merged into First Citizens and its FirstNet operations.





Based on total bank deposits in Hardin County, First Citizens ranks third in size compared to all banks operating in Hardin County.  Total assets were $296 million and total deposits were $250 million at December 31, 2010.





Citizens Northern and Subsidiary


On December 6, 2005, the Company acquired Citizens Bancorp in Newport, Kentucky.  Citizens Bancorp was subsequently merged into Citizens Acquisition, a former bank holding company subsidiary of the Company. During January 2007, Citizens Acquisition was merged into the Company, leaving Citizens Northern as a direct subsidiary of the Company. Citizens Northern is a state chartered bank organized in 1993 and is engaged in a general banking business providing full service banking to individuals, businesses, and governmental customers.  It conducts business in its principal office in Newport and four branches in Campbell County, Kentucky, one branch in Boone County, Kentucky and two branches in Kenton County, Kentucky. Based on total bank deposits in Campbell County, Citizens Northern ranks third in size compared to all banks operating in Campbell County.  At year-end 2010 it had total assets and deposits of $250 million and $201 million, respectively. Citizens Financial Services, formerly an investment brokerage subsidiary of Citizens Acquisition, was dissolved during 2006.





In March 2008 Citizens Northern incorporated ENKY Properties, Inc. (“ENKY”). ENKY was established to manage and liquidate certain real estate properties repossessed by Citizens Northern. In addition, ENKY holds a 17% interest in NUBT, the parent company of Flowing Creek. Flowing Creek holds real estate that has been repossessed by Citizens Northern and United Bank along with parties unrelated to the Company. NUBT holds a 67% interest in Flowing Creek and unrelated financial institutions hold the remaining 33% interest. ENKY had total assets of $1.1 million at year-end 2010.




14





Nonbank Subsidiaries


FCB Services, organized in 1992, provides data processing services and support for the Company and its subsidiaries.  It is located in Frankfort, Kentucky. It also performs data processing services for nonaffiliated entities.  FCB Services had total assets of $3.2 million at December 31, 2010.





Kentucky General was incorporated in November 2004. Kentucky General previously held a 50% voting interest in KHL Holdings prior to its sale during the third quarter of 2009.  KHL Holdings owned a 100% interest in KHL Insurance that it acquired in 2005. KHL Insurance writes credit life and health insurance in Kentucky.





EKT was created in September 2008 to manage and liquidate certain real estate properties repossessed by the Company’s subsidiary banks. On December 31, 2010, EKT had total assets of $4.1 million.





Kentucky General Life Insurance Company was incorporated during 2000 to engage in insurance activities permitted by federal and state law.  This corporation has remained inactive since its inception and was dissolved during 2010.





Trust I, Trust II, and Trust III are each separate Delaware statutory business trusts sponsored by the Company.  The Company completed two private offerings of trust preferred securities during 2005 through Trust I and Trust II totaling $25.0 million. During 2007, the Company completed a private offering of trust preferred securities totaling $22.5 million. The Company owns all of the common securities of each of the Trusts. The Company does not consolidate the Trusts into its financial statements consistent with applicable accounting standards.





FFKT Insurance was incorporated during 2005. It is a captive property and casualty insurance company insuring primarily deductible exposures and uncovered liability related to properties of the Company. It had total assets of $3.3 million at December 31, 2010.





Lending Summary


A significant part of the Company’s operating activities include originating loans, approximately 87% of which are secured by real estate at December 31, 2010.  Real estate lending primarily includes loans secured by owner and non-owner occupied one-to-four family residential properties as well as commercial real estate mortgage loans to developers and owners of other commercial real estate.  Real estate lending primarily includes both variable and adjustable rate products.  Loan rates on variable rate loans generally adjust upward or downward immediately based on changes in the loan’s index, normally prime rate as published in the Wall Street Journal.  Rates on adjustable rate loans move upward or downward after an initial fixed term of normally one, three, or five years. Rate adjustments on adjustable rate loans are made annually after the initial fixed term expires and are indexed mainly to shorter-term Treasury indexes.  Generally, variable and adjustable rate loans contain provisions that cap the amount of interest rate increases over the life of the loan of up to 600 basis points and lifetime floors of 100 basis points. In addition to the lifetime caps and floors on rate adjustments, loans secured by residential real estate typically contain provisions that limit annual increases at a maximum of 100 basis points. There is typically no annual limit applied to loans secured by commercial real estate.





The Company also makes fixed rate commercial real estate loans to a lesser extent with repayment terms generally not exceeding 12 months.  The Company’s subsidiary banks make first and second residential mortgage loans secured by real estate not to exceed 90% loan to value without seeking third party guarantees.  Commercial real estate loans are made primarily to small and mid-sized businesses, secured by real estate not exceeding 80% loan to value.  Other commercial loans are asset based loans secured by equipment and lines of credit secured by receivables and include lending across a diverse range of business types.





Commercial lending and real estate construction lending, including commercial leasing, generally includes a higher degree of credit risk than other loans, such as residential mortgage loans.  Commercial loans, like other loans, are evaluated at the time of approval to determine the adequacy of repayment sources and collateral requirements.  Collateral requirements vary to some degree among borrowers and depend on the borrower’s financial strength, the terms and amount of the loan, and collateral available to secure the loan.  Credit risk results from the decreased ability or willingness to pay by a borrower.  Credit risk also results when a liquidation of collateral occurs and there is a shortfall in collateral value as compared to a loan’s outstanding balance.  For construction loans, inaccurate initial estimates of a project’s costs and the property’s completed value could weaken the Company’s position and lead to the property having a value that is insufficient to satisfy full payment of the amount of funds advanced for the property.  Secured and unsecured consumer loans generally are made for automobiles, boats, and other motor vehicles.  In most cases loans are restricted to the subsidiaries' general market area.





Loan Policy


The Company has a company-wide lending policy in place that is amended and approved from time to time as needed to reflect current economic conditions and product offerings in its markets.  The policy has established minimum standards that each of its bank subsidiaries must adopt. Additionally, the policy is subject to amendment based on positive and negative trends observed within the lending portfolio as a whole.  As an example, the loan to value limits contained within the policy were reduced during 2009 due to the declining economy and the attendant real estate market decline.  While new appraisals now reflect that decline, appraisal reviews and downward adjustments are a




15








The Company’s subsidiary banks may amend their lending policy so long as the amendment is no less stringent than the company-wide lending policy. These amendments are done within the control structure and oversight of the parent company.  The Company’s board of directors voted in favor of a recommendation from management during 2009 to create the position of Chief Credit Officer.  This position oversees all lending at affiliate institutions where the size and risk of individual credits are deemed significant to the Company.  The Chief Credit Officer also monitors trends in asset quality, portfolio composition, concentrations of credit, reports of examinations, internal audit reports, work-out strategies for large credits, and other responsibilities as matters evolve.





Procedures


The lending policy lists the products and credit services offered by each of the Company’s subsidiary banks.   Each product and service has an established written procedure to adhere to when transacting business with a customer.   The lending policy also establishes pre-determined lending authorities for loan officers commensurate with their abilities and experience.  Further, the policy establishes committees to review and approve or deny credit requests at various lending amounts.  This includes subcommittees of the bank boards of directors and, at certain lending levels, the entire bank board.





Generally, for loans in excess of $1 million, the bank subsidiaries full board of directors will be presented with the loan request. This only occurs when the credit has first been recommended by the loan officer and chief credit officer, and then by the directors’ loan committee.  When loan requests are within policy guidelines and the amount requested is within their lending authority, lenders are permitted to approve and close the transaction.  A review of the loan file and documentation takes place within 30 days to ensure policy and procedures are being followed.  Approval authorities are under regular review for adjustment by affiliate management and the parent company.  Loan requests outside of standard policy may be made on a case by case basis when justified, documented, and approved by the board of directors of the subsidiary bank.





Underwriting


Underwriting criteria for all types of loans are prescribed within the lending policy.





Residential Real Estate


Residential real estate mortgage lending makes up the largest portion of the loan portfolio.  The outstanding balances in this classification of loans have been stable, representing roughly one-third of the portfolio in each of the previous five-year period. This component of the loan portfolio has experienced the least amount of delinquency and charge offs within the affiliated banks.





Underwriting criteria and procedures for residential real estate mortgage loans include:





·
Monthly debt payments of the borrower to gross monthly income should not exceed 45% with stable employment.


·
Interest rate shocks are applied for variable rate loans to determine repayment capabilities at elevated rates.


·
Loan to value limits of up to 90%. Loan to value ratios exceeding 90% require additional third party guarantees.


·
A thorough credit investigation using the three nationally available credit repositories.


·
Incomes and employment is verified.


·
Insurance is required in an amount to fully replace the improvements with the lending bank named as loss payee/mortgagee.


·
Flood certifications are procured to ensure the improvements are not in a flood plain or are insured if they are within the flood plain boundaries.


·
Collateral is investigated using current appraisals and is supplemented by the loan officer’s knowledge of the locale and salient factors of the local market.  Only appraisers which are state certified or licensed and on the banks’ approved list are utilized to perform this service.


·
Title attorneys and closing agents are required to maintain malpractice liability insurance and be on the banks approved list.


·
Secondary market mortgages must meet the underwriting criteria of the purchasers, which is generally the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation.


·
Adjustable rate owner occupied home loans are tied to market based rates such as are published by the Federal Reserve, commonly the one year constant maturity Treasury bill is used.


·
Residential real estate mortgage loans are made for terms not to exceed 30 years.




16


Commercial Real Estate


Commercial real estate lending underwriting criteria is documented in the lending policy. Underwriting criteria and procedures for commercial real estate loans include:





·
Procurement of Federal income tax returns and financial statements for the past 3 years and related supplemental information deemed relevant.


·
Detailed financial and credit analysis is performed and presented to various committees.


·
Cash investment from the applicant in an amount equal to 20% of cost (loan to value ratio not to exceed 80%).  Additional collateral may be taken in lieu of a full 20% investment in limited circumstances.


·
Cash flows from the project financed and global cash flow of the principals and their entities must produce a minimum debt coverage ratio of 1.25:1.


·
Past experience of the customer with the bank.


·
Experience of the investor in commercial real estate.


·
Tangible net worth analysis.


·
Interest rate shocks for variable rate loans.


·
General and local commercial real estate conditions.


·
Alternative uses of the security in the event of a default.


·
Thorough analysis of appraisals.


·
References and resumes are procured for background knowledge of the principals/guarantors.


·
Credit enhancements are utilized when necessary and or desirable such as assignments of life insurance and the use of guarantors and firm take-out commitments.


·
Frequent financial reporting is required for income generating real estate such as:  rent rolls, tenant listings, average daily rates and occupancy rates for hotels.


·
Commercial real estate loans are made with amortization terms not to exceed 20 years.





Real Estate Construction


Real estate construction lending has declined due to recent economic conditions. Where the Company’s markets continue to demonstrate demand, construction lending is continuing with close monitoring of the local economy. At year-end 2010, real estate construction lending comprised approximately 13% of the total loan portfolio.





Real estate construction lending underwriting criteria is documented in the lending policy. Underwriting criteria and procedures for such lending include:





·
20% capital injection from the applicant (loan to value ratio not to exceed 80%).


·
25% capital injection for land acquisition for development (loan to value ratio not to exceed 75%).


·
Pre-sell, pre-lease, and take out commitments are procured and evaluated/verified.


·
Draw requests require documentation of expenses.


·
On site progress inspections are completed to protect the lending bank affiliate.


·
Control procedures are in place to minimize risk on construction projects such as conducting lien searches and requiring affidavits.


·
Lender on site visits and periodic financial discussions with owners/operators.


·
Real estate construction loans are made for terms not to exceed 12 months and 18 months for residential and commercial purposes, respectively.





Commercial, Financial, and Agriculture


Commercial, financial, and agriculture lending underwriting criteria is documented in the lending policy. Underwriting criteria and procedures for such loans are detailed below.





For commercial loans secured by business assets, the following loan to value ratios and debt coverage are required by policy:





·
Inventory 50%.


·
Accounts receivable less than 90 days past due 75%.


·
Furniture, fixtures, and equipment 60%.


·
Borrowing-base certificates are required for monitoring asset based loans.


·
Stocks, bonds, and mutual funds are often pledged by business owners. Marketability and volatility is taken into account when valuing these types of collateral and lending is generally limited to 60% of their value.


·
Debt coverage ratios from cash flows must meet the policy minimum of 1.25:1.  This coverage applies to global cash flow and guarantors, if any.


·
Commercial loans secured by business assets are made for terms to match the economic useful lives of the asset securing the loan. Loans secured by furniture, fixtures, and equipment are made for terms not to exceed seven years.




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Loans to financial institutions are generally secured by the capital stock of the financial institution with a loan to value ratio not to exceed 60% and repayment terms not exceeding 10 years. Capital stock values of non-public companies are determined by common metrics such as a multiple of tangible book value or by obtaining third party estimates. Financial covenants are also obtained that require the borrower to maintain certain levels of asset quality, capital adequacy, liquidity, profitability, and regulatory compliance. At year-end 2010, loans to financial institutions were $16.4 million. The Company has not experienced any loan losses related to financial institutions.





Agricultural lending, such as for tobacco or corn, is limited to 75% of expected sales proceeds while lending for cattle and farm equipment is capped at 80% loan to value.





Interest Only Loans


Interest only loans are limited to construction lending and properties recently completed and undergoing an occupancy stabilization period.  These loans are short-term in nature, usually with maturities of less than one year.





Installment Loans


Installment lending is a relatively small component of the Company’s portfolio mix, reflecting 2.4% of outstanding loans at year-end 2010.  These loans predominantly are direct loans to established bank customers and primarily include the financing of automobiles, boats, and other consumer goods.  The character, capacity, collateral, and conditions are evaluated using policy restraints. Installment loans are made for terms of up to 5 years.





Installment lending underwriting criteria and procedures for such financing include:





·
Required financial statement of the applicant for loans in excess of $20,000.


·
Past experience of the customer with the bank.


·
Monthly debt payments of the borrower to gross monthly income should not exceed 45% with stable employment.


·
Secured and unsecured loans are made with a definite repayment plan which coincides with the purpose of the loan.


·
Borrower’s unsecured debt must not exceed 25% of the borrower’s net worth.


·
Verification of borrower’s income.





Lease Financing


Lease financing is also a relatively small component of the Company’s portfolio, representing 1.3% of outstanding loans at year-end 2010.  Lease receivables are generally obtained through indirect sources such as equipment brokers and dealers.  The board of directors of the Company’s Leasing One subsidiary has reduced the staff and curtailed new lending in this environment for the present time.  Servicing existing leases and terming out residuals are the extent of its ongoing activity at the present time.





Lease financing underwriting criteria is documented by policy. Underwriting criteria and procedures for such financing include:





·
Lessee must be a commercial entity.


·
Lessee must be in business for a minimum of two years.


·
Leased equipment must be of essential use to lessee’s business.


·
Residual positions taken will not exceed 20% of original equipment cost.


·
Leasing terms generally not to exceed five years; used equipment and computers not to exceed three years.


·
Personal and/or corporate financial statements or tax returns required for all financing requests. Submission of updated financial statements annually.


·
Credit reports must be clear of judgments and bankruptcies and chronic delinquency paying habits.


·
Bank and trade references must report satisfactory references.





Hybrid Loans


The Company and its subsidiary banks have a policy of not underwriting, originating, selling or holding hybrid loans.  The Company does not currently hold hybrid loans.  Hybrid loans include payment option adjustable rate mortgages (ARM’s), negative amortization loans, and stated income/stated asset loans.





Appraisals


The value of real estate in the Company’s markets has generally declined as a result of the economic downturn beginning in 2008. Net charge-offs have been negatively impacted by slower sales and excess inventory related to loans secured by real estate developments. The slower sales and excess inventory has decreased the cash flow and financial prospects of many borrowers, particularly those in the real estate development and related industries and reduced the estimated fair value of the collateral securing these loans.




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The Company uses independent third party state-certified or licensed appraisers. These appraisers take into account local market conditions when preparing their estimate of fair value. However, management of the Company will often include refinements in the appraised value for estimated costs to sell as required under relevant accounting standards.





The Company evaluates appraisals it receives from independent third parties subsequent to the appraisal date by monitoring transactions in its markets and comparing them to its projects that are similar in nature. The Company’s internal audit department periodically reviews appraisals on a test basis to determine that assumptions used in appraisals remain valid and are not stale. New appraisals are obtained if market conditions significantly impact collateral values for those loans that are identified as impaired. Internal audit reviews appraisals related to all of the Company’s impaired loans and repossessed properties at least annually.





The Company considers appraisals it receives on one property as a means to extrapolate the estimated value for other collateral of similar characteristics if that property may not otherwise have a need for an appraisal. Should a borrower’s financial condition continue to deteriorate, an updated appraisal on that specific collateral will be obtained.





Appraisals obtained for construction and development lending purposes are performed by state licensed or state-certified appraisers who are credentialed and on the Company’s approved list.  Plans and specifications are provided to the appraiser by bank personnel not directly involved in the credit approval process.  The appraisals conform to the standards of appraisal practices established by the Appraisal Standards Board in effect at the time of the appraisal. This includes net present value accounting for construction and development loans on an “as completed” basis.





Appraisal reviews are conducted internally by bank personnel familiar with the local market and who are not directly involved in the credit approval process.  Bank personnel do not increase the valuation from the appraisal but may, in some instances, make a reduction. Upon completion, a follow up site visit by the appraiser is completed to verify the property was improved per the original plans and specifications and recertify, if appropriate, the original estimate of “as completed” market value.  There are two circumstances where management may make adjustments to appraisals:





As discussed above, construction and development appraisals are on an “as completed” basis.  If work remains to be completed on a financed project, management will reduce the estimated value in the appraisal by the cost estimated to complete the work and, if required by the loan balance, establish reserves allocated to the loan or write down the loan based on the need to complete such work.





If an appraisal for given collateral is still valid (e.g. less than one year old, etc.), but due to market conditions and the bank’s familiarity with comparable property sales in the market the appraised value appears high, management may adjust downward from the last appraisal its estimate of the value of the collateral and, in turn, establish reserves allocated to the loan or write down the loan to reflect this downward adjustment.





Loan to value ratios are typically well under 100% at inception which gives the Company a cushion as collateral values fall.  However, when updated appraisals reveal collateral exposure (i.e. the value of the collateral is less than originally estimated and no longer supports the loan balance), negotiations ensue with the borrower aimed at providing additional collateral support for the credit.  This may be in many forms as determined by the financial holdings of the borrower.  If not available, third party support for the credit is pursued (e.g., guarantors, equity investors).  If negotiations fail to provide additional adequate collateral support, reserves are allocated to the loan or the loan is written down to the fair value of the collateral less the estimated costs to sell.





When a construction loan or development loan is downgraded, a new appraisal is ordered contemporaneously with the downgrade.  The appraisers are instructed to give a fair value based upon both an “as is” basis and an “as completed” basis.  The twofold purpose is to facilitate management’s decision making process in determining the cost benefits of completing a project vs. marketing the project as is.





The carrying value of a downgraded loan or non performing asset wherein the underlying collateral is an incomplete project is based on a fresh appraisal at the “as is” value.  The current appraisal is a compilation of the most recent sales available and therefore includes the risk premium established by the market conditions.  When the comparable sales are not deemed to be reliable or the adjustments are not satisfactory, management will make appropriate adjustments to the fair value which includes a risk premium (discount) deducted using the discounted cash flow framework.  The reserve or write down is expended upon completion of the appraisal and other relevant information assessment.





Interest Reserves


Interest reserves represent funds loaned to a borrower for the payment of interest during the development phase on certain construction and development loans. Interest reserves were a common industry practice when banks were more actively lending in their markets and the




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Since the real estate market has diminished over time, the Company has been less active in construction and development lending and the use of the interest reserves. For present and future construction and development loan requests, borrowers must show sufficient cash reserves and significant excess cash flow from all sources in addition to other underwriting criteria measures.  The projects viability is a major consideration as well, along with the probability of its stabilization and/or sale.





Due to the general lack of opportunities currently in our markets combined with our low desire for this segment of the lending portfolio, interest reserves are not commonplace.





Supervision and Regulation


The Company and its subsidiaries are subject to comprehensive supervision and regulation that affect virtually all aspects of their operations. These laws and regulations are primarily intended to protect depositors and borrowers and, to a lesser extent, stockholders. Changes in applicable laws, regulations, or in the policies of banking and other government regulators may have a material adverse effect on our current or future business. The following summarizes certain of the more important aspects of the relevant statutory and regulatory provisions.




Supervisory Authorities


The Company is a bank holding company, registered with and regulated by the Federal Reserve Board (“FRB”). All four of its subsidiary banks are Kentucky state-chartered banks. Two of the Company’s subsidiary banks are members of their regional Federal Reserve Bank. The Company and its subsidiary banks are subject to supervision, regulation and examination by the Federal Deposit Insurance Corporation (“FDIC”) and the Kentucky Department of Financial Institutions (“KDFI”).  The regulatory authorities routinely examine the Company and its subsidiary banks to monitor their compliance with laws and regulations, financial condition, adequacy of capital and reserves, quality and documentation of loans, payment of dividends, adequacy of systems and controls, credit underwriting and asset liability management, and the establishment of branches. The Company and its subsidiary banks are required to file regular reports with the FRB, the FDIC and the KDFI, as applicable.


Capital


The FRB, the FDIC, and the KDFI require the Company and its subsidiary banks to meet certain ratios of capital to assets in order to conduct their activities. To be well-capitalized, the institutions must generally maintain a Total Risk-based Capital ratio of 10% or greater, a Tier 1 Risk-based Capital ratio of 6% or greater, and a Tier 1 Leverage ratio of 5% or more. For the purposes of these tests, Tier 1 Capital consists of common equity and related surplus, retained earnings, and a limited amount of qualifying preferred stock, less goodwill (net of certain deferred tax liabilities) and certain core deposit intangibles. Tier 2 Capital consists of non-qualifying preferred stock, certain types of debt and a limited amount of other items. Total Capital is the sum of Tier 1 and Tier 2 Capital.




In measuring the adequacy of capital, assets are generally weighted for risk. Certain assets, such as cash and U.S. government securities, have a zero risk weighting. Others, such as commercial and consumer loans, have a 100% risk weighting. Risk weightings are also assigned for off-balance sheet items such as loan commitments. The various items are multiplied by the appropriate risk-weighting to determine risk-adjusted assets for the capital calculations. For the leverage ratio mentioned above, average assets (as defined) are used and are not risk-weighted.




If the institution fails to remain well-capitalized, it will be subject to a series of restrictions that increase as the capital condition worsens. For instance, federal law generally prohibits a depository institution from making any capital distribution, including the payment of a dividend or paying any management fee to its holding company, if the depository institution would be undercapitalized as a result. Undercapitalized depository institutions may not accept brokered deposits absent a waiver from the FDIC, are subject to growth limitations, and are required to submit a capital restoration plan for approval, which must be guaranteed by the institution’s parent holding company. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. Critically undercapitalized institutions are subject to the appointment of a receiver or conservator.





In December 2010, the Basel Committee on Banking Supervision issued final rules related to global regulatory standards on bank capital adequacy and liquidity (commonly referred to as “Basel III”) previously agreed on by the Group of Governors and Heads of Supervision (the oversight body of the Basel Committee).  The new rules present details of the Basel III framework, which includes increased capital requirements and limits the types of instruments that can be included in Tier 1 capital.





Basel III includes the following provisions: (i) that the minimum ratio of common equity to risk weighted assets be increased to 4.5% from the current level of 2%, to be fully phased in by January 1, 2015, and (ii) that the minimum requirement for the Tier 1 Risk-based capital




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Basel III also includes a “capital conservation buffer” requiring banking organizations to maintain an additional 2.5% of Tier 1 common equity to total risk weighted assets in addition to the minimum requirement. This requirement will be phased in between January 1, 2016 and January 1, 2019. The capital conservation buffer is designed to absorb losses in periods of financial and economic distress and, while banks are allowed to draw on the buffer during periods of stress, if a bank’s regulatory capital ratios approach the minimum requirement, the bank will be subject to more stringent constraints on dividends and bonuses. In addition, Basel III includes a countercyclical buffer of up to 2.5%, which could be imposed by countries to address economies that appear to be building excessive system-wide risks due to rapid growth.





To constrain the build-up of excess leverage in the banking system, Basel III introduces a new non-risk-based leverage ratio. A minimum Tier 1 Leverage ratio of 3% will be tested during a parallel run period between January 1, 2013 and January 1, 2017. Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017.





The impact from Basel III is not expected to have a material impact on the Company’s level of capital since current levels are in excess of the requirements.





Basel III includes two separate standards for supervising liquidity risks which include: (i) a “liquidity coverage ratio” designed to ensure that banks have a sufficient amount of high-quality liquid assets to survive a significant liquidity stress scenario over a 30-day period, (ii) a “net stable funding ratio” designed to promote more medium and long-term funding of the assets and activities of banks over a one-year time horizon. After an observation period beginning in 2011, the liquidity coverage ratio will become effective on January 1, 2015. The revised net stable funding ratio will become effective January 1, 2018.





Basel III implementation in the U.S. will require that regulations and guidelines be issued by U.S. banking regulators, which may significantly differ from the recommendations published by the Basel Committee.





Expansion and Activity Limitations


With prior regulatory approval, the Company may acquire other banks or bank holding companies and its subsidiaries may merge with other banks. Acquisitions of banks located in other states may be subject to certain deposit-percentage, age or other restrictions. During the third quarter of 2009, the Company withdrew its financial company election with the sale of its KHL subsidiary. Financial holding companies and their subsidiaries are permitted to acquire or engage in activities such as insurance underwriting, securities underwriting and distribution, travel agency activities, broad insurance agency activities, merchant banking, and other nonbanking activities that the FRB determines to be financial in nature or complementary to these activities.The FRB normally requires some form of notice or application to engage in or acquire companies engaged in such activities. Under the Bank Holding Company Act and Gramm-Leach-Bliley Act, the Company is generally prohibited from engaging in or acquiring direct or indirect control of more than 5% of the voting shares of any company engaged in activities other than those referred to above.




Limitations on Acquisitions of Bank Holding Companies


In general, other companies seeking to acquire control of a bank holding company such as the Company would require the approval of the FRB under the Bank Holding Company Act. In addition, individuals or groups of individuals seeking to acquire control of a bank holding company such as the Company would need to file a prior notice with the FRB (which the FRB may disapprove under certain circumstances) under the Change in Bank Control Act. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the bank holding company. Control may exist under the Change in Bank Control Act if the individual or company acquires 10% or more of any class of voting securities of the bank holding company and no shareholder holds a larger percentage of the subject class of voting securities.




Deposit Insurance


Each of the Company’s subsidiary banks are members of the FDIC, and their deposits are insured by the FDIC’s Deposit Insurance Fund (“DIF”) up to the amount permitted by law. The Company’s subsidiary banks are thus subject to FDIC deposit insurance assessments. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank’s capital level and supervisory rating.





In February 2009, the FDIC adopted a long-term DIF restoration plan as well as an additional emergency assessment for 2009. The restoration plan increased base assessment rates for banks in all risk categories with the goal of raising the DIF reserve ratio from its then-current .40% to its statutorily mandated minimum of 1.15% within eight years (as amended). Beginning April 1, 2009 the FDIC established a bank’s initial base assessment rate ranging between 12 and 45 basis points, depending on the banks risk category. The initial base assessment rate is then adjusted higher or lower to obtain the total base assessment rate. Adjustments to the initial base assessment rate are based on a bank’s




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The FDIC adopted an emergency special assessment in 2009 which superseded its interim rule that would have imposed a 20 basis point assessment with an option for an additional 10 basis point assessment. Under the final rule adopted, the FDIC imposed a special assessment of 5 basis points on a bank’s total assets minus Tier 1 capital as of June 30, 2009 and collected September 30, 2009. The Company paid $1.1 million related to the 2009 special assessment. The final rule also authorized the FDIC to impose up to two additional 5 basis points assessments if needed while capping each assessment at 10 basis points of the banks assessment base.





In addition to the FDIC’s special assessment for 2009, the FDIC in November 2009 approved a final rule requiring banks to prepay their estimated quarterly assessments for the fourth quarter of 2009 as well as all of 2010, 2011, and 2012 on December 30, 2009. The prepayment was adopted by the FDIC in lieu of an additional special assessment as summarized in the preceding paragraph. The assessment rate used for all periods covered in the prepayment plan was the bank’s assessment rate in effect as of September 30, 2009, increased by 3 basis points for all of 2011 and 2012. The prepayment was based on a bank’s regular assessment base (total domestic deposits) as of September 30, 2009, with a quarterly increase of an estimated 5% annual growth rate through the end of 2012. The prepaid assessment is applied against actual future quarterly assessments until exhausted.  Any funds remaining after June 30, 2013 will be returned to the institution.  Requiring this prepaid assessment does not limit the FDIC from changing assessment rates or from further revising the risk-based assessment system. The Company paid $8.2 million on December 30, 2009 related to this assessment. Prepaid FDIC insurance assessments are included in other assets on the Company’s balance sheet.





The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) requires changes to a number of components of the FDIC insurance assessment with an implementation date of April 1, 2011. The Dodd-Frank Act requires the FDIC to adopt a new DIF restoration plan to ensure that the reserve ratio increases to 1.35% from 1.15% of insured deposits by 2020. Under the new restoration plan, the FDIC will forego the uniform three-basis point increase in initial assessment rates scheduled to take place on January 1, 2011. The FDIC has proposed new regulations that would redefine the assessment base as average consolidated assets less average tangible equity.  The proposed regulations would use the current assessment rate schedule with modifications to the unsecured debt and brokered deposit adjustments, and eliminate the secured liability adjustment. At least semi-annually, the FDIC will update its loss and income projections for the DIF and, if needed, increase or decrease assessment rates. In establishing assessments, the FDIC is required to offset the effect of the higher reserve ratio against insured depository institutions with total consolidated assets of less than $10 billion.





In addition to deposit insurance assessments, all FDIC-insured institutions are required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation (“FICO”), a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 possessing assessment powers in addition to the FDIC. The FDIC acts as a collection agent for FICO, whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings & Loan Insurance Corporation. FICO assessment rates are determined quarterly and will continue until the FICO bonds mature in 2017.





During the fourth quarter of 2010, the FDIC issued a final rule implementing provisions of the Dodd-Frank Act that provide for temporary unlimited coverage for noninterest-bearing transaction accounts. The separate coverage for noninterest-bearing transaction accounts became effective on December 31, 2010 and terminates on December 31, 2012.





Under the Dodd-Frank Act, the maximum deposit insurance amount has been permanently increased from $100 thousand to $250 thousand and unlimited deposit insurance has been extended to noninterest-bearing transaction accounts until December 31, 2012.





Other Statutes and Regulations


The Company and its subsidiary banks are subject to a myriad of other statutes and regulations affecting their activities. Some of the more important are:




Anti-Money Laundering. Financial institutions are required to establish anti-money laundering programs that must include the development of internal policies, procedures, and controls; the designation of a compliance officer; an ongoing employee training program; and an independent audit function to test the performance of the programs. The Company and its subsidiary banks are also subject to prohibitions against specified financial transactions and account relationships as well as enhanced due diligence and “know your customer” standards in their dealings with foreign financial institutions and foreign customers.  Financial institutions must take reasonable steps to conduct enhanced scrutiny of account relationships in order to guard against money laundering and to report any suspicious transactions. Recent laws provide the law enforcement authorities with increased access to financial information maintained by banks.




Sections 23A and 23B of the Federal Reserve Act. The Company’s subsidiary banks are limited in their ability to lend funds or engage in transactions with the Company or other nonbank affiliates of the Company, and all transactions must be on an arms’-length basis and on terms at least as favorable to the subsidiary bank as prevailing at the time for transactions with unaffiliated companies.




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Dividends. The Parent Company’s principal source of cash flow, including cash flow to pay dividends to its shareholders, is the dividends that it receives from its subsidiary banks. Statutory and regulatory limitations apply to the subsidiary banks’ payments of dividends to the Parent Company as well as to the Parent Company’s payment of dividends to its shareholders. A depository institution may not pay any dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. The federal banking agencies may prevent the payment of a dividend if they determine that the payment would be an unsafe and unsound banking practice. Moreover, the federal agencies have issued policy statements that provide that bank holding companies and insured banks should generally only pay dividends out of current operating earnings. The Parent Company and certain of its bank subsidiaries are currently under regulatory orders that restrict the payment of dividends. For further information please refer to the caption “Recent Regulatory Events and Increased Capital Requirements” below.





The Company’s participation in the Capital Purchase Program (“CPP”) beginning in the first quarter of 2009 includes certain restrictions on the Company’s ability to pay dividends to its common shareholders. The Company is unable to declare dividend payments on shares of its common stock if it is in arrears on the dividends on its Series A preferred stock issued in connection with its participation in the CPP. Additionally, until January 9, 2012 the Company must have approval from the U.S. Treasury (“Treasury”) before it can increase dividends on its common stock above the last quarterly cash dividend per share it declared prior to October 14, 2008, which was $.33 per share. This restriction no longer applies if all of the Series A preferred stock has been redeemed by the Company or transferred by the Treasury. Additional information about the CPP can be found under the caption titled “Emergency Economic Stabilization Act of 2008 (“EESA”)” that follows.




Community Reinvestment Act. The Company’s subsidiary banks are subject to the provisions of the Community Reinvestment Act of 1977 (“CRA”), as amended, and the federal banking agencies’ related regulations, stating that all banks have a continuing and affirmative obligation, consistent with safe and sound operations, to help meet the credit needs for their entire communities, including low and moderate-income neighborhoods. The CRA requires a depository institution’s primary federal regulator, in connection with its examination of the institution or its evaluation of certain regulatory applications, to assess the institution’s record in assessing and meeting the credit needs of the community served by that institution, including low and moderate-income neighborhoods. The regulatory agency’s assessment of the institution’s record is made available to the public.





Insurance Regulation.  The Company’s subsidiaries that may underwrite or sell insurance products are subject to regulation by the Kentucky Department of Insurance.




Consumer Regulation.  The activities of the Company and its bank subsidiaries are subject to a variety of statutes and regulations designed to protect consumers. These laws and regulations:




·
limit the interest and other charges collected or contracted for by all of the Company’s subsidiary banks;


·
govern disclosures of credit terms to consumer borrowers;


·
require financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;


·
prohibit discrimination on the basis of race, creed, or other prohibited factors in extending credit;


·
require all of the Company’s subsidiary banks to safeguard the personal non-public information of its customers, provide annual notices to consumers regarding the usage and sharing of such information and limit disclosure of such information to third parties except under specific circumstances; and


·
govern the manner in which consumer debts may be collected by collection agencies.




The deposit operations of the Company’s subsidiary banks are also subject to laws and regulations that:




·
require disclosure of the interest rate and other terms of consumer deposit accounts;


·
impose a duty to maintain the confidentiality of consumer financial records and prescribe procedures for complying with administrative subpoenas of financial records; and


·
govern automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services.





Emergency Economic Stabilization Act of 2008 (“EESA”). EESA was signed into law on October 3, 2008 as a measure to stabilize and provide liquidity to the U.S. financial markets. Under EESA, the Troubled Asset Relief Program (“TARP”) was created. TARP granted the Treasury authority to, among other things, invest in financial institutions and purchase troubled assets in an aggregate amount up to $700 billion.





In connection with TARP, the CPP was launched on October 14, 2008. Under the CPP, the Treasury announced a plan to use up to $250 billion of TARP funds to purchase equity stakes in certain eligible financial institutions, including the Company. The Company was preliminarily approved for $30 million of equity capital in December 2008 with the transaction closing in January 2009. In the transaction, the Company issued 30 thousand shares of fixed-rate cumulative perpetual preferred stock to the Treasury. The Company must pay a 5% cumulative dividend during the first five years the preferred shares are outstanding, resetting to 9% thereafter if not redeemed, and includes




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As required by the CPP, the Company also issued a warrant to the Treasury to purchase common shares equal to 15% of the value of the preferred stock, with the number of warrants and exercise price determined based on the 20-day average closing price of the common shares ending on the day prior to preliminary approval. The warrants allow the U.S. Treasury to purchase 223,992 shares of Company common stock at an exercise price of $20.09 per share. Both the preferred shares and warrants are accounted for as additions to the Company’s regulatory capital.





Temporary Liquidity Guarantee Program (“TLGP”). The TLGP consists of two separate programs implemented by the FDIC in October 2008. This includes the Debt Guarantee Program (“DGP”) and the Transaction Account Guarantee Program (“TAGP”). These programs were initially provided at no cost to participants during the first 30 days. Eligible institutions that do not “opt out” of either of these programs become participants by default and will incur the fees assessed for taking part.





Under the DGP, as amended, eligible participating entities were permitted to issue senior unsecured debt guaranteed by the FDIC through October 31, 2009. The guarantee by the FDIC would expire on the earlier of the maturity date of the debt or December 31, 2012. During October 2009 the FDIC adopted final rules to phase out the DGP. The DGP expired October 31, 2009; however, the FDIC established a six month emergency guarantee facility effective upon the expiration of the DGP. Subject to its prior approval, the FDIC will provide guarantees of senior debt issued after October 31, 2009 through April 30, 2010 with the guarantee expiring on the earlier of the maturity date of the debt or December 31, 2012. The Company chose to opt out of the DGP.





Under the TAGP, the FDIC guarantees 100% of certain noninterest bearing transaction accounts up to any amount to participating FDIC insured institutions. The unlimited coverage, set to initially expire on December 31, 2009, was extended by the FDIC in August 2009 with an expiration date of June 30, 2010. In April 2010, the FDIC further extended the TAGP to December 31, 2010 and adopted rules that allowed extending the program an additional twelve months without further rulemaking. However, amendments related to the enactment of the Dodd-Frank Act now provide full deposit insurance coverage for noninterest bearing deposit transaction accounts beginning December 31, 2010 for an additional two year period. No opt-out option is permitted and there is no separate assessment applicable to the covered accounts.





The Company opted to participate in the TAGP, including the extension period. All participating institutions initially paid an additional 10 basis point quarterly-assessed fee on certain noninterest bearing transaction accounts that exceed the existing $250 thousand deposit insurance limit. The Company incurred the additional 10 basis point annual fee through the original expiration date of December 31, 2009 of the program. For coverage after December 31, 2009, the program included an increase in the annualized assessment based on an institutions risk category. Institutions in risk category one and two were subject to a 15 basis point and 20 basis point fee assessment, respectively. Institutions in risk category three and four were subject to a 25 basis point fee assessment.





Dodd-Frank Act.On July 21, 2010, the Dodd-Frank Act was signed into law by President Obama. The Dodd-Frank Act implements far-reaching changes to the regulation of the financial services industry, including provisions that will:




·
Centralize responsibility for consumer financial protection by creating a new agency responsible for implementing, examining and enforcing compliance with federal consumer financial laws.


·
Apply the same leverage and risk-based capital requirements that apply to insured depository institutions to bank holding companies.


·
Require the federal banking regulators to seek to make their capital requirements countercyclical, so that capital requirements increase in times of economic expansion and decreases in times of economic contraction.


·
Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital.


·
Provide for new disclosure and other requirements relating to executive compensation and corporate governance.


·
Make permanent the $250 thousand limit for federal deposit insurance and provide unlimited federal deposit insurance until January 1, 2013 for noninterest bearing demand transaction accounts at all insured depository institutions.


·
Repeal the federal prohibitions on the payment of interest on commercial demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.


·
Increase the authority of the Federal Reserve to examine non-bank subsidiaries.


·
Codify and expand the “source of strength” doctrine as a statutory requirement. The source of strength doctrine represents the long held policy view by the Federal Reserve that a bank holding company should serve as a source of financial strength for its subsidiary banks.




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Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on the Company, its customers or the financial industry more generally. Provisions in the legislation that affect deposit insurance assessments and payment of interest on commercial demand deposits could increase the costs associated with deposits as well as place limitations on certain revenues those deposits may generate.





References under the caption “Supervision and Regulation” to applicable statutes and regulations are brief summaries of portions thereof which do not purport to be complete and which are qualified in their entirety by reference thereto.





Recent Regulatory Events and Increased Capital Requirements


The Company’s subsidiary banks are subject to capital-based regulatory requirements.  The Company has historically managed its banks’ capital levels with the goal of meeting the criteria established by its regulators for each bank subsidiaries to be “well-capitalized.” Historically, to be well-capitalized, a depository institution needed to have a Tier 1 leverage capital ratio of at least 5% and a Total risk-based capital ratio of 10%.  As of December 31, 2010, each of the Company’s four subsidiary banks satisfied these capital ratios.





Although each of the Company’s subsidiary banks was well-capitalized as of December 31, 2010, some of their capital levels have decreased in recent years as a result of the economic downturn that began in late 2007.  Because of the turmoil in the banking markets and continued difficulty many banks are experiencing with their loan portfolios, bank regulatory agencies are increasingly requiring banks to maintain higher capital reserves as a cushion for dealing with any further deterioration in their loan portfolios in order to maintain well-capitalized status.  Primarily as a result of examinations that took place in 2009, the Company’s banking regulators have required higher minimum capital ratios that have required capital infusions at certain of the Company’s banking subsidiaries and have taken other supervisory actions. A summary of the capital requirements resulting from the regulatory actions are described below. For a more complete discussion and additional information regarding these regulatory actions, please refer to the section captioned “Capital Resources” under Item 7 “Management’s Discussion and Analysis of Financial Condition and Result of Operations” part of this Form 10-K.





Parent Company. In the summer of 2009 the FRB St. Louis conducted an examination of the Parent Company.  Primarily due to the regulatory actions and capital requirements at three of the Company’s subsidiary banks (as discussed below), the FRB St. Louis and KDFI proposed the Company enter into a Memorandum of Understanding (“Memorandum”).  The Company’s board approved entry into the Memorandum at a regular board meeting during the fourth quarter of 2009.  Pursuant to the Memorandum, the Company agreed that it would develop an acceptable capital plan to ensure that the consolidated organization remains well-capitalized and each of its subsidiary banks meet the capital requirements imposed by their regulator as summarized below.





The Company also agreed to reduce its common stock dividend in the fourth quarter of 2009 from $.25 per share down to $.10 per share and not make interest payments on the Company’s trust preferred securities or dividends on its common or preferred stock without prior approval from FRB St. Louis and KDFI.  Representatives of the FRB St. Louis and KDFI have indicated that any such approval for the payment of dividends will be predicated on a demonstration of adequate, normalized earnings on the part of the Company’s subsidiaries sufficient to support quarterly payments on the Company’s trust preferred securities and quarterly dividends on the Company’s common and preferred stock.  While both regulatory agencies have granted approval of all subsequent quarterly Company requests to make interest payments on its trust preferred securities and dividends on its preferred stock, the Company has not (based on the assessment by Company management of both the Company’s capital position and the earnings of its subsidiaries) sought regulatory approval for the payment of common stock dividends since the fourth quarter of 2009.  Moreover, the Company will not pay any such dividends on its common stock in any subsequent quarter until the regulator’s assessment of the earnings of the Company’s subsidiaries, and the Company’s assessment of its capital position, both yield the conclusion that the payment of a Company common stock dividend is warranted.





Other components in the regulatory order for the parent company include requesting and receiving regulatory approval for the payment of new salaries/bonuses or other compensation to insiders; assisting its subsidiary banks in addressing weaknesses identified in their reports of examinations; providing periodic reports detailing how it will meet its debt service obligations; and providing progress reports with its compliance with the regulatory Memorandum.





Farmers Bank.  Farmers Bank was the subject of a regularly scheduled examination by the KDFI which was conducted in mid-September 2009.  As a result of this examination, the KDFI and FRB St. Louis entered into a Memorandum with Farmers Bank.  The Memorandum requires that Farmers Bank obtain written consent prior to declaring or paying the Parent Company a cash dividend and to achieve and maintain a Tier 1 Leverage ratio of 8.0% by June 30, 2010.  The Parent Company injected from its reserves $11 million in capital into Farmers Bank subsequent to the Memorandum.





At June 30, 2010, Farmers Bank had a Tier 1 Leverage ratio of 7.98% and a Total Risk-based Capital ratio of 15.78%. Subsequent to June 30, 2010, the Parent Company injected into Farmers Bank an additional $200 thousand in capital in order to raise its Tier 1 Leverage ratio to 8.0% to comply with the Memorandum. At December 31, 2010 Farmers Bank had a Tier 1 Leverage ratio of 8.55% and a Total Risk-based Capital ratio of 16.86%.





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Other parts of the regulatory order include the development and documentation of plans for reducing problem loans, providing progress reports on compliance with the Memorandum, developing and implementing a written profit plan and strategic plans, and evaluating policies and procedures for monitoring construction loans and use of interest reserves. It also restricts the bank from extending additional credit to borrowers with credits classified as substandard, doubtful or special mention in the report of examination.





Lawrenceburg Bank. As a result of an examination conducted in March 2009, on May 15, 2009, Lawrenceburg Bank entered into a Memorandum with the FRB St. Louis and the KDFI. This Memorandum terminated effective upon Lawrenceburg Bank’s merger into Farmers Bank on May 8, 2010.





United Bank.  As a result of an examination conducted in late July and early August of 2009, the FDIC proposed United Bank enter into a Cease and Desist Order (“Order”) primarily as a result of its level of nonperforming assets.  The Order requires United Bank to obtain written consent prior to declaring or paying the Parent Company a cash dividend and achieve and maintain a Tier 1 Leverage ratio of 8.0% by June 30, 2010 and a Total Risk-based Capital ratio of 12% immediately.   Subsequent to the Order, the Parent Company injected $10.5 million from its reserves into United Bank. In April 2010, the Parent Company injected an additional $1.9 million of capital into United Bank to bring its Tier 1 Leverage ratio up to the minimum 7.75% as of March 31, 2010 as required by the Order.  At June 30, 2010, United Bank had a Tier 1 Leverage ratio of 8.06% and a Total Risk-based Capital ratio of 14.12%. At December 31, 2010, United Bank had a Tier 1 Leverage ratio of 8.24% and a Total Risk-based Capital ratio of 14.18%.





Other components in the regulatory order include stricter oversight and reporting to its regulators in terms of complying with the Order. It also includes an increase in the level of reporting by management to its board of directors of its financial results, budgeting, and liquidity analysis, as well as restricting the bank from extending additional credit to borrowers with credits classified as substandard, doubtful or special mention in the report of examination.





Citizens Northern.  Citizens Northern was the subject of a regularly scheduled examination by the KDFI which was completed in late May 2010.  As a result of this examination, the KDFI and the FDIC on September 8, 2010 entered into a Memorandum with Citizens Northern.  The Memorandum requires that Citizens Northern obtain written consent prior to declaring or paying a dividend and to increase Tier 1 Leverage ratio to equal or exceed 7.5% prior to September 30, 2010 and to achieve and maintain Tier 1 Leverage ratio to equal or exceed 8.0% prior to December 31, 2010.  In December 2010, the Parent Company injected $250 thousand of capital into Citizens Northern to bring its Tier 1 Leverage ratio up to the minimum 8.0% as of year-end 2010 as required by the Order.  At December 31, 2010, Citizens Northern had a Tier 1 Leverage ratio of 8.04% and a Total Risk-based Capital ratio of 12.68%.





Other parts of the regulatory order include the development and documentation of plans for reducing problem loans, providing progress reports on compliance with the Memorandum, and for the development and implementation of a written profit plan and strategic plans. It also restricts the bank from extending additional credit to borrowers with credits classified as substandard, doubtful or special mention in the report of examination.





At the Parent Company and at each of its bank subsidiaries, the Company believes it is adequately addressing all issues of the regulatory agreements to which it is subject. However, only the respective regulatory agencies can determine if compliance with the applicable regulatory agreements have been met. The Company and its subsidiary banks are in compliance with the requirements identified in the regulatory agreements as of December 31, 2010, with the exception that the level of substandard loans at Farmers Bank exceed the target amount by $1.3 million. Regulators continue to monitor the Company’s progress and compliance with the agreements through periodic on-site examinations, regular communications, and quarterly data analysis. The results of these examinations and communications show satisfactory progress toward meeting the requirements included in the regulatory agreements.





The Parent Company maintains cash available to fund a certain amount of additional injections of capital to its bank subsidiaries if required by its regulators. If needed, further amounts in excess of available cash may be funded by future public or private sales of securities, although the Parent Company is currently under no directive by its regulators to raise any additional capital.





Competition


The Company and its subsidiaries face vigorous competition for banking services from various types of businesses other than commercial banks and savings and loan associations.  These include, but are not limited to, credit unions, mortgage lenders, finance companies, insurance companies, stock and bond brokers, financial planning firms, and department stores which compete for one or more lines of banking business.  The Company also competes for commercial and retail business not only with banks in Central and Northern Kentucky, but with banking organizations from Ohio, Indiana, Tennessee, Pennsylvania, and North Carolina which have banking subsidiaries located in Kentucky.  These competing businesses may possess greater resources and offer a greater number of branch locations, higher lending limits, and may offer other services not provided by the Company. In addition, the Company’s competitors that are not depository institutions are generally not subject to the extensive regulations that apply to the Company and its subsidiary banks. The Company has attempted to offset some of the advantages of its competitors by arranging participations with other banks for loans above its legal lending limits, expanding into additional markets and





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product lines, and entering into third party arrangements to better compete for its targeted customer base. Competition from other providers of financial services may reduce or limit the Company’s profitability and market share.





The Company competes primarily on the basis of quality of services, interest rates and fees charged on loans, and the rates of interest paid on deposit funds. The business of the Company is not dependent upon any one customer or on a few customers, and the loss of any one or a few customers would not have a material adverse effect on the Company.





No material portion of the business of the Company is seasonal. No material portion of the business of the Company is subject to renegotiation of profits or termination of contracts or subcontracts at the election of the government, though certain contracts are subject to such renegotiation or termination.





The Company is not engaged in operations in foreign countries.




Employees


As of December 31, 2010, the Company and its subsidiaries had 512 full-time equivalent employees. Employees are provided with a variety of employee benefits. A salary savings plan, group life insurance, hospitalization, dental, and major medical insurance along with postretirement health insurance benefits are available to eligible personnel.  Employees are not represented by a union. Management and employee relations are good.





The Company maintains a Stock Option Plan (“Plan”) that grants certain eligible employees the option to purchase a limited number of the Company’s common stock. The Plan specifies the conditions and terms that the grantee must meet in order to exercise the options.





In 2004, the Company’s Board of Directors adopted an Employee Stock Purchase Plan (“ESPP”). The ESPP was subsequently approved by the Company’s shareholders and became effective July 1, 2004. Under the ESPP, at the discretion of the Board of Directors, employees of the Company and its subsidiaries can purchase Company common stock at a discounted price and without payment of brokerage costs or other fees and in the process benefit from the favorable tax treatment afforded such plans pursuant to Section 423 of the Internal Revenue Code.





Available Information


The Company makes available, free of charge through its website (www.farmerscapital.com), its Code of Ethics, its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after electronically filing such material with the SEC.





Item1A. Risk Factors





Investing in the Company’s common stock is subject to risks inherent to the Company’s business. The material risks and uncertainties that management believes affect the Company are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Company’s business operations. This report is qualified in its entirety by these risk factors.





If any of the following risks actually occur, the Company’s financial condition and results of operations could be materially and adversely affected. If this were to happen, the market price of the Company’s common stock could decline significantly, and shareholders could lose all or part of their investment.





The Company operates in a highly regulated environment and may be adversely affected by changes in federal and state laws and regulations, including rules and policies applicable to participants in the U.S. Treasury’s TARP Capital Purchase Program.





The Company is subject to extensive regulation, supervision and examination by federal and state banking authorities. Any change in applicable regulations or laws could have a substantial adverse impact on the Company and its operations.  Additional legislation and regulations that could significantly affect the Company’s powers, authority and operations may be enacted or adopted in the future, which could have a material adverse effect on the Company’s results of operations and financial condition.  Further, in the performance of their supervisory duties and enforcement powers, the Company’s banking regulators have significant discretion and authority to prevent or remedy practices they deem as unsafe or unsound or violations of law.





As a recipient of investment by the Treasury in our Series A preferred stock under the CPP, the Company is subject to current and future regulations of the Treasury and acts of Congress related to that program.   The laws and policies applicable to recipients of capital under the CPP have been significantly revised and supplemented since the inception of that program, and continue to evolve.




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The exercise of regulatory authority generally may have a negative impact on the Company’s operations, which may be material on its results of operations and financial condition.





The Company presently is subject to, and in the future may become subject to, additional supervisory actions and/or enhanced regulation that could have a material negative effect on its business, operating flexibility, financial condition and the value of its common stock.


Under federal and state laws and regulations pertaining to the safety and soundness of insured depository institutions, the KDFI (for state-chartered banks), the Board of Governors of the Federal Reserve (the “Federal Reserve”) (for bank holding companies) and separately the FDIC as the insurer of bank deposits, have the authority to compel or restrict certain actions on the Company’s part if they determine that the Company has insufficient capital or are otherwise operating in a manner that may be deemed to be inconsistent with safe and sound banking practices. Under this authority, bank regulators can require the Company to enter into informal or formal enforcement orders, including board resolutions, memoranda of understanding, written agreements and consent or cease and desist orders, pursuant to which the Company would be required to take identified corrective actions to address cited concerns and to refrain from taking certain actions.





Primarily as a result of increased levels of nonperforming assets, the Parent Company, Farmers Bank, and Citizens Northern have entered into separate Memoranda of Understanding with our regulators and United Bank has consented to a Cease and Desist order from its regulators.  In the aggregate, these Memoranda of Understanding and the Cease and Desist Order, among other things, require (1) the Company to develop an acceptable capital plan to ensure that the consolidated organization remains well-capitalized and each of its subsidiary banks meet the capital requirements imposed by their regulator as described elsewhere in this report, (2) increase the regulatory capital ratios at these three banks, (3) these three banks refrain from paying dividends to the Parent Company unless approved in advance by the regulators and (4) the Company not make future interest payments on its trust preferred securities or dividends on its common or preferred stock without seeking prior approval from FRB St. Louis and KDFI.  Representatives of the FRB St. Louis and KDFI have indicated that any such approval for the payment of dividends will be predicated on a demonstration of adequate, normalized earnings on the part of the Company’s subsidiaries sufficient to support quarterly payments on the Company’s trust preferred securities and quarterly dividends on the Company’s common and preferred stock.  While both regulatory agencies have granted approval of all subsequent quarterly Company requests to make interest payments on its trust preferred securities and dividends on its preferred stock, the Company has not (based on the assessment by Company management of both the Company’s capital position and the earnings of its subsidiaries) sought regulatory approval for the payment of common stock dividends since the fourth quarter of 2009.  Moreover, the Company will not pay any such dividends on its common stock in any subsequent quarter until the regulator’s assessment of the earnings of the Company’s subsidiaries, and the Company’s assessment of its capital position, both yield the conclusion that the payment of a Company common stock dividend is warranted.





If the Company is unable to comply with the terms of its current regulatory orders, or is unable to comply with the terms of any future regulatory orders to which it may become subject, then we could become subject to additional, heightened supervisory actions and orders, possibly including cease and desist orders, prompt corrective actions and/or other regulatory enforcement actions. If the Company’s regulators were to take such additional supervisory actions, then we could, among other things, become subject to significant restrictions on our ability to develop any new business, as well as restrictions on our existing business, and we could be required to raise additional capital, dispose of certain assets and liabilities within a prescribed period of time, or both. If one or more of the Company’s banks were unable to comply with regulatory requirements, such banks could ultimately face failure.  The terms of any such supervisory action could have a material negative effect on our business, operating flexibility, financial condition and the value of our common stock.





Our nonperforming assets adversely affect our results of operations and financial condition and take significant management time to resolve.





As of December 31, 2010, nonperforming loans (which include restructured loans of $37.0 million) totaled $91.0 million or 7.6% of the Company’s loan portfolio. Nonperforming assets (which include foreclosed real estate) were $122 million or 6.3% of total assets at year-end 2010.  In addition, loans past due 30-89 days and still accruing were $6.7 million as of December 31, 2010. Nonperforming assets adversely affect the Company’s net income in various ways.  If economic conditions do not improve or actually worsen in our markets, the Company could continue to incur additional losses relating to an increase in nonperforming assets.  The Company does not record interest income on nonaccrual loans or other real estate owned, thereby adversely affecting interest income.  When the Company takes collateral in foreclosures and similar proceedings, it is required to mark the related loan to the fair value of the collateral less estimated selling costs, which decreases earnings.  These loans and other real estate owned also increase our risk profile and the amount of capital the Company’s regulators believe is appropriate in light of such risks.  While the Company seeks to reduce its problem loans through workouts, restructurings and otherwise, decreases in the value of these assets, the underlying collateral or our borrowers’ performance or financial conditions have adversely affected, and may continue to adversely affect, the Company’s results of operations and financial condition.  Moreover, the resolution of nonperforming assets requires significant time commitments from management of our banks, which can be detrimental to the performance of their other responsibilities. There can be no assurance that the Company will not experience further increases in nonperforming loans in the future.




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Losses from loan defaults may exceed the allowance established for that purpose, which will have an adverse effect on the Company’s financial condition.





Volatility and deterioration in the broader economy increases the Company’s risk of credit losses, which could have a material adverse effect on its operating results.  If a significant number of loans in the Company’s portfolio are not repaid, it would have an adverse effect on its earnings and overall financial condition.  Like all banks, the Company’s subsidiaries maintain an allowance for loan losses to provide for losses inherent in the loan portfolio.  The allowance for loan losses reflects management of each subsidiary’s best estimate of probable incurred credit losses in their loan portfolio at the relevant balance sheet date.  This evaluation is primarily based upon a review of the bank’s and the banking industry’s historical loan loss experience, known risks contained in the bank’s loan portfolio, composition and growth of the bank’s loan portfolio and economic factors.  Additionally, a bank’s regulators may require additional provision for the loan portfolio in connection with regulatory examinations, agreements or orders.  The determination of an appropriate level of loan loss allowance is an inherently difficult process and is based on numerous assumptions.  As a result, the Company’s allowance for loan losses may be inadequate to cover actual losses in its loan portfolio.  Consequently, the Company risks having additional future provisions for loan losses that may continue to adversely affect its earnings.





If the Company’s local markets experience a prolonged recession or economic downturn, it may be required to make further increases in its allowance for loan losses and to charge off additional loans, which would adversely affect its results of operations and capital.





For the year 2010, the Company recorded a provision for loan losses of $17.2 million, which includes $3.6 million for the fourth quarter, and recorded net loan charge-offs of $11.8 million, $2.6 million of which was in the fourth quarter.  This compares to a provision for loan losses of $20.8 million and net loan charge-offs of $14.2 million for 2009, and a $6.5 million provision and $5.2 million of net loan charge-offs which were recorded for the fourth quarter of 2009.





Substantially all of the Company’s loans are to businesses and individuals located in Kentucky.  A continuing or prolonged decline in the economy of Central and Northern Kentucky could have a material adverse effect on the Company’s financial condition, results of operations and prospects.





Generally, the Company’s nonperforming loans and assets reflect operating difficulties of individual borrowers; however, more recently the deterioration in the general economy has become a significant contributing factor to the increased levels of delinquencies and nonperforming loans.  Slower sales and excess inventory in the residential housing market has been the primary cause of the increase in delinquencies and foreclosures for residential construction and land development loans.  As of December 31, 2010, the Company’s total nonperforming loans had increased to $91.0 million or 7.6% of  loans compared to $76.3 million or 6.0% of loans at December 31, 2009. If current trends in the housing and real estate markets continue, the Company expects that it will continue to experience higher than normal delinquencies and credit losses.  Moreover, the Company expects that a prolonged recession or economic downturn could severely impact economic conditions in its market areas and that it could experience significantly higher delinquencies and credit losses.  As a result, the Company may be required to make further increases in its provision for loan losses and to charge off additional loans in the future, which could adversely affect the Company’s financial condition and results of operations, perhaps materially.  If such additional provisions and charge-offs cause the Company to experience losses, it may be required to contribute additional capital to its bank subsidiaries to maintain capital ratios required by regulators.





The Company’s exposure to credit risk is increased by its real estate development lending.





Real estate development loans have dominated the Company’s increase in impaired loans.  Substantially all of the Company’s $54.0 million nonaccrual loans outstanding at December 31, 2010 are secured by real estate.  Development lending has historically been considered to be higher credit risk than single-family residential lending.  Such loans typically involve larger loan balances to a single borrower or related borrowers. Such loans can be affected by adverse conditions in real estate markets or the economy in general because commercial real estate borrowers’ ability to repay their loans depends on successful development and, in most cases, sale of their property. These loans also involve greater risk because they generally are not fully amortized over the loan period, but have a balloon payment due at maturity of the loan.  A borrower’s ability to make a balloon payment typically will depend on being able to either refinance the loan or timely sell the underlying property.  In the current economic environment, the ability of borrowers to refinance or sell newly developed property or vacant land has greatly diminished.  If the real estate markets were to worsen or not improve, the Company would likely experience increased credit losses and require additional provisions to our allowance for loan losses, which would adversely impact the Company’s earnings and financial condition.





The Company’s investment securities portfolio is comparatively larger than other community banks and it is more dependent on its investment portfolio to generate net income.





Unlike many other community banks, the Company relies more heavily on its investment securities portfolio as a source of interest income because it has a comparatively small loan portfolio.  If the Company is not able to successfully manage the interest rate spread on the investment




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In 2010 the Company sold and realized net gains on investment securities.  The Company may not have the same level of net gains (and may have net realized losses) in future periods on the sale of investment securities, which would reduce earnings.  Moreover, due to the current interest rate environment, proceeds from recent sales may be reinvested in investment securities with lower yields which may reduce earnings from investment securities.





The Company continually monitors its investment securities portfolio for deteriorating values and for other-than-temporary impairments.  Any material other-than-temporary impairments would likewise have an adverse affect on the Company’s results of operations and could lead to additional losses.





The Company cannot accurately predict the effect of the current economy on its future results of operations or the market price of its stock.





The national economy and the financial services sector in particular continue to face unique challenges. The Company cannot accurately predict the severity or duration of the current economic downturn, which has adversely impacted its performance and the markets it serves.  Any further deterioration in the economies of the nation as a whole or in the Company’s local markets would have an adverse effect, which could be material, on the Company’s financial condition, results of operations and prospects, and could also cause the market price of the Company’s stock to decline.  While it is impossible to predict how long these conditions may exist, the economic downturn could continue to present risks for some time for our industry and the Company.





Interest rate volatility could significantly harm the Company’s results of operations.





The Company’s results of operations are affected by the monetary and fiscal policies of the federal government, the policies of the Company’s regulators, and the prevailing interest rates in the United States and the Company’s markets.  In addition, it is increasingly common for the Company’s competitors, who may be aggressively seeking to attract deposits as a result of increased liquidity concerns arising from changing economic or other conditions, to pay rates on deposits that are much higher than normal market rates.  A significant component of the Company’s earnings is the net interest income of its subsidiary banks, which is the difference between the income from interest earning assets, such as loans, and the expense of interest bearing liabilities, such as deposits.  A change in market interest rates could adversely affect the Company’s earnings if market interest rates change such that the interest it pays on deposits and borrowings increases faster than the interest it collects on loans and investments; or, alternatively, if interest rates earned on earning assets decline faster than those rates paid on interest paying liabilities.  Consequently, as with most financial institutions, the Company is sensitive to interest rate fluctuations.





The FDIC has increased deposit insurance premiums to restore and maintain the federal deposit insurance fund, which has increased costs to the Company.





Under the Federal Deposit Insurance Act, as amended by the Dodd-Frank Act, the FDIC must establish and implement a plan to restore the deposit insurance fund’s designated reserve ratio to 1.35% of insured deposits by 2020. The Dodd-Frank Act removed the previously established upper limit reserve ratio of 1.15%. The FDIC must continue to assess and consider the appropriate level of the reserve ratio annually by considering each of the following: risk of loss to the insurance fund; economic conditions affecting the banking industry; the prevention of sharp swings in the assessment rates; and any other factors the FDIC deems important. In December 2010 the FDIC announced that it had established the long-term reserve ratio at 2.0%.





The FDIC previously implemented a restoration plan that changed both its risk-based assessment system and its base assessment rates. As part of this plan, during the second quarter of 2009 it increased deposit insurance assessment rates generally and imposed a special assessment of five basis points on each insured institution’s total assets less Tier 1 capital.  The special assessment in 2009, which was in addition to the regular quarterly risk-based assessment, totaled approximately $1.1 million for the Company.





In the wake of a rapid depletion of the FDIC’s Deposit Insurance Fund resulting from a high number of bank failures, the FDIC required that all (with limited exceptions) insured institutions pay in the fourth quarter of 2009 its following estimated three years’ quarterly deposit assessments in advance.  This resulted in an aggregate payment by the Company’s bank subsidiaries totaling $8.2 million in the fourth quarter of 2009.  The three years’ advance payment was recorded as a prepaid asset that is being expensed in approximately equal amounts over prepayment period and, thus, only impact earnings in the normal course.  However, the advance payment reduced the liquid assets of the Company’s bank subsidiaries at the time of payment.





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The Company expects that assessment rates may continue to increase in the near term due to the significant cost of  bank failures, the relatively large number of troubled banks that may fail in the future, and the requirement that the FDIC increase the reserve ratio. Any increase in assessments could adversely impact the Company’s future earnings and liquidity.





The recent repeal of federal prohibitions on the payment of interest on demand deposits of business customers could increase the Company’s interest expense.




Federal prohibitions against financial institutions paying interest on demand deposit accounts of business customers were repealed as part of the Dodd-Frank Act. As a result, beginning on July 21, 2011, financial institutions can offer to pay interest on commercial demand deposits to compete for customers. The Company cannot predict the interest rates other institutions may offer. The Company’s interest expense is expected to increase and its net interest margin is expected to decrease should it begin to pay interest on commercial demand deposits to attract additional customers or to keep current customers. This could result in a material adverse impact on the Company’s financial condition and results of operations.





Any future losses may require the Company to raise additional capital; however, such capital may not be available to us on favorable terms or at all.





The Company is required by federal and state regulatory authorities to maintain levels of capital to support its operations.  Furthermore, in the wake of recent regularly scheduled examinations of three of its subsidiaries, the Company’s regulators have required these three banks to raise their capital to levels significantly above the well-capitalized benchmark.  The Company’s ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time and on the Company’s future financial condition and performance.  Accordingly, the Company cannot make assurances with respect to its ability to raise additional capital on favorable terms, or at all.  If the Company cannot raise additional capital when needed, its ability to further expand its operations through internal growth and acquisitions could be materially impaired and its financial condition and liquidity could be materially and adversely affected. The Parent Company is currently under no directive by its regulators to raise any additional capital.





The tightening of available liquidity could limit the Company’s ability to replace deposits and fund loan demand, which could adversely affect its earnings and capital levels.





A tightening of the credit and liquidity markets and the Company’s inability to obtain adequate funding to replace deposits may negatively affect its earnings and capital levels.  In addition to deposit growth, maturity of investment securities and loan payments from borrowers, the Company relies from time to time on advances from the Federal Home Loan Bank and other wholesale funding sources to fund loans and replace deposits.  In the event of a further downturn in the economy, these additional funding sources could be negatively affected which could limit the funds available to the Company.  The Company’s liquidity position could be significantly constrained if it were unable to access funds from the Federal Home Loan Bank or other wholesale funding sources.





The Company’s financial condition and outlook may be adversely affected by damage to its reputation.





The Company’s financial condition and outlook is highly dependent upon perceptions of its business practices and reputation. Its ability to attract and retain customers and employees could be adversely affected to the extent its reputation is damaged. Negative public opinion could result from its actual or alleged conduct in any number of activities, including regulatory actions taken against the Company, lending practices, corporate governance, regulatory compliance, mergers of its subsidiaries, or sharing or inadequate protection of customer information.  Damage to the Company’s reputation could give rise to loss of customers and legal risks, which could have an adverse impact on its financial condition.





The Company faces strong competition from financial services companies and other companies that offer banking services.





The Company conducts most of its operations in Central and Northern Kentucky. The banking and financial services businesses in these areas are highly competitive and increased competition in its primary market areas may adversely impact the level of its loans and deposits. Ultimately, the Company may not be able to compete successfully against current and future competitors. These competitors include national banks, regional banks and other community banks. The Company also faces competition from many other types of financial institutions, including savings and loan associations, finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries. In particular, the Company’s competitors include major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous locations and mount extensive promotional and advertising campaigns. Areas of competition include interest rates for loans and deposits, efforts to obtain loan and deposit customers and a range in quality of products and services provided, including new technology-driven products and services. If the Company is unable to attract and retain banking customers, it may be unable to continue its loan growth and level of deposits.





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The Company’s financial results could be adversely affected by changes in accounting standards or tax laws and regulations.





The Financial Accounting Standards Board and the SEC frequently change the financial accounting and reporting standards that govern the preparation of the Company’s financial statements. In addition, from time to time, federal and state taxing authorities will change the tax laws, regulations, and their interpretations. These changes and their effects can be difficult to predict and can materially and adversely impact how the Company records and reports its financial condition and results of operations.





The short term and long term impact of changes to banking capital standards could negatively impact the Company’s regulatory capital and liquidity.





In December 2010, the Basel Committee on Banking Supervision issued final rules related to global regulatory standards on bank capital adequacy and liquidity. The new rules present details of the Basel III framework, which includes increased capital requirements and limits the types of instruments that can be included in Tier 1 capital.





Basel III includes the following provisions: (i) that the minimum ratio of common equity to risk weighted assets be increased to 4.5% from the current level of 2%, to be fully phased in by January 1, 2015, and (ii) that the minimum requirement for the Tier 1 Risk-based capital ratio will be increased from 4% to 6%, to be fully phased in by January 1, 2015. The new minimums will be phases in starting January 1, 2013.





Basel III also includes a “capital conservation buffer” requiring banking organizations to maintain an additional 2.5% of Tier 1 common equity to total risk weighted assets in addition to the minimum requirement. This requirement will be phased in between January 1, 2016 and January 1, 2019. The capital conservation buffer is designed to absorb losses in periods of financial and economic distress and, while banks are allowed to draw on the buffer during periods of stress, if a bank’s regulatory capital ratios approach the minimum requirement, the bank will be subject to more stringent constraints on dividends and bonuses. In addition, Basel III includes a countercyclical buffer of up to 2.5%, which could be imposed by countries to address economies that appear to be building excessive system-wide risks due to rapid growth.





To constrain the build-up of excess leverage in the banking system, Basel III introduces a new non-risk-based leverage ratio. A minimum Tier 1 Leverage ratio of 3% will be tested during a parallel run period between January 1, 2013 and January 1, 2017. Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017.





Basel III includes two separate standards for supervising liquidity risks which include: (i) a “liquidity coverage ratio” designed to ensure that banks have a sufficient amount of high-quality liquid assets to survive a significant liquidity stress scenario over a 30-day period, (ii) a “net stable funding ratio” designed to promote more medium and long-term funding of the assets and activities of banks over a one-year time horizon. After an observation period beginning in 2011, the liquidity coverage ratio will become effective on January 1, 2015. The revised net stable funding ratio will become effective January 1, 2018.





Basel III implementation in the U.S. will require that regulations and guidelines be issued by U.S. banking regulators, which may significantly differ from the recommendations published by the Basel Committee.





The Company cannot predict at this time the precise content of capital and liquidity guidelines or regulations that may be adopted by regulatory agencies having authority over us and our subsidiaries, or the impact that any changes in regulation would have on the Company. However, we expect that the new standards will generally require the Company or our banking subsidiaries to maintain more capital, with common equity as a more predominant component, or manage the configuration of our assets and liabilities in order to comply with new liquidity requirements, which could significantly impact our return on equity, financial condition, operations, capital position and ability to pursue business opportunities.





The price of the Company’s common stock may fluctuate significantly, and this may make it difficult to resell it when you want or at prices you find attractive.





The Company cannot predict how its common stock will trade in the future.  The market value of its common stock will likely continue to fluctuate in response to a number of factors including the following, most of which are beyond our control, as well as the other factors described in this “Risk Factors” section:





·
general economic conditions and conditions in the financial markets,


·
changes in global financial markets, such as interest or foreign exchange rates, stock, commodity or real estate valuations or volatility and other geopolitical events,


·
conditions in our local and national credit, mortgage and housing markets,


·
developments with respect to financial institutions generally, including government regulation,




32




·
our dividend practice, and


·
actual and anticipated quarterly fluctuations in our operating results and earnings.




The market value of the Company’s common stock may also be affected by conditions affecting the financial markets in general, including price and trading fluctuations. These conditions may result in: (1) volatility in the level of, and fluctuations in, the market prices of stocks generally and, in turn, the Company’s common stock and (2) sales of substantial amounts of the Company’s common stock in the market, in each case that could be unrelated or disproportionate to changes in the Company’s operating performance. These broad market fluctuations may adversely affect the market value of the Company’s common stock.





There may be future sales of additional common stock or other dilution of the Company’s equity, which may adversely affect the market price of the Company’s common stock.





The Company is not restricted from issuing additional common stock or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities. The market price of the Company’s common stock could decline as a result of sales by the Company of a large number of shares of common stock or preferred stock or similar securities in the market or from the perception that such sales could occur.





The Company’s board of directors is authorized generally to cause it to issue additional common stock, as well as series of preferred stock, without any action on the part of the Company’s shareholders except as may be required under the listing requirements of the NASDAQ Stock Market. In addition, the board has the power, without shareholder approval, to set the terms of any series of preferred stock that may be issued, including voting rights, dividend rights, preferences and other terms.  This could include preferences over the common stock with respect to dividends or upon liquidation.  If the Company issues preferred stock in the future that has a preference over the common stock with respect to the payment of dividends or upon liquidation, or if the Company issues preferred stock with voting rights that dilute the voting power of the common stock, the rights of holders of the common stock or the market price of the common stock could be adversely affected. The Parent Company is currently under no directive by its regulators to raise any additional capital.





You may not receive dividends on the Company’s common stock.





Holders of the Company’s common stock are entitled to receive dividends only when, as and if its board of directors declares them, and as permitted by its regulators.  Although the Company has (up through 2009) historically declared quarterly cash dividends on its common stock, it is not required to do so.  The Company’s board of directors reduced its quarterly common stock dividend in January 2009 from $.33 per share to $.25 per share and again in October 2009 to $.10 per share. The Company also agreed to not make interest payments on its trust preferred securities or dividends on its common or preferred stock without prior approval from FRB St. Louis and KDFI.  Representatives of the FRB St. Louis and KDFI have indicated that any such approval for the payment of dividends will be predicated on a demonstration of adequate, normalized earnings on the part of the Company’s subsidiaries sufficient to support quarterly payments on the Company’s trust preferred securities and quarterly dividends on the Company’s common and preferred stock.  However, there can be no assurance the Company’s regulators will provide such approvals in the future.





While both regulatory agencies have granted approval of all subsequent quarterly Company requests to make interest payments on its trust preferred securities and dividends on its preferred stock, the Company has not (based on the assessment by Company management of both the Company’s capital position and the earnings of its subsidiaries) sought regulatory approval for the payment of common stock dividends since the fourth quarter of 2009.  Moreover, the Company will not pay any such dividends on its common stock in any subsequent quarter until the regulator’s assessment of the earnings of the Company’s subsidiaries, and the Company’s assessment of its capital position, both yield the conclusion that the payment of a Company common stock dividend is warranted.





In addition, the Company’s payment of dividends is subject to certain restrictions as a result of its issuance of Series A preferred stock to the Treasury on January 9, 2009 under the TARP CPP.  The dividends declared on the Company’s Series A preferred stock reduce the net income available to common stockholders and reduce earnings per common share.  Moreover, under the terms of the Company’s articles of incorporation, it is unable to declare dividend payments on shares of its common stock if it is in arrears on the dividends on the Series A preferred stock.  Further, until January 9, 2012, the Company must have the Treasury’s approval before it may increase dividends on its common stock above the amount of the last quarterly cash dividend per share we declared prior to October 14, 2008, which was $.33 per share.  This restriction no longer applies if all the Series A preferred stock has been redeemed by the Company or transferred by the Treasury.





If the Company is in arrears on interest payments on its trust preferred securities, it may not pay dividends on its common stock until such interest obligations are brought current.


33


The Company’s ability to pay dividends depends upon the results of operations of its subsidiary banks and certain regulatory considerations.





The Parent Company is a bank holding company that conducts substantially all of its operations through its subsidiary banks. As a result, the Company’s ability to make dividend payments on its common stock depends primarily on certain federal and state regulatory considerations and the receipt of dividends and other distributions from its bank subsidiaries. There are various regulatory restrictions on the ability of three of our subsidiary banks to pay dividends or make other payments to the Parent Company and its ability to make payments to its shareholders, including certain regulatory approvals of dividends or distributions. There can be no assurance that the Company will receive such approval or that it will resume paying dividends to shareholders.





The trading volume in the Company’s common stock is less than that of many other similar companies.





The Company’s common stock is listed for trading on the NASDAQ Global Select Stock Market.  As of December 31, 2010 the 50-day average trading volume of the Company’s common stock on NASDAQ was 7,143 shares or .10% of the total common shares outstanding of 7,411,676.  An efficient public trading market is dependent upon the existence in the marketplace of willing buyers and willing sellers of a stock at any given time. The Company has no control over such individual decisions of investors and general economic and market conditions. Given the lower trading volume of the Company’s common stock, larger sales volumes of its common stock could cause the value of its common stock to decrease.  Moreover, due to its lower trading volume it may take longer to liquidate your position in the Company’s common stock.





There can be no assurance when the Company’s Series A preferred stock and related warrant issued to the Treasury can be redeemed.





Subject to consultation with banking regulators, the Company intends to repurchase the Series A preferred stock, and potentially the warrant, it issued to the Treasury when it believes the credit metrics in its loan portfolio have improved for the long-term and the overall economy has rebounded. However, there can be no assurance when the Series A preferred stock and warrant held by the Treasury can be repurchased, if at all. Until such time as the Series A preferred stock are repurchased, the Company will remain subject to the terms and conditions of those instruments, which, among other things, limit the Company’s ability to repurchase or redeem common stock or increase the dividends on its common stock over $.33 per share prior to 2012. Further, the Company’s continued participation in the CPP subjects it to increased regulatory and legislative oversight, including with respect to executive compensation. These new and any future oversight and legal requirements and implementing standards under the CPP may have unforeseen or unintended adverse effects on the financial services industry as a whole, and particularly on CPP participants such as the Company.





Holders of the Company’s Series A preferred stock have rights that are senior to those of the Company’s common stockholders.





The Series A preferred stock that the Company issued to the Treasury is senior to the Company’s shares of common stock, and holders of the Series A preferred stock have certain rights and preferences that are senior to holders of the Company’s common stock. The restrictions on the Company’s ability to declare and pay dividends to common stockholders are discussed above. In addition, the Company and its subsidiaries may not purchase, redeem or otherwise acquire for consideration any shares of the Company’s common stock unless the Company has paid in full all accrued dividends on the Series A preferred stock for all prior dividend periods, other than in certain circumstances. Furthermore, the Series A preferred stock is entitled to a liquidation preference over shares of the Company’s common stock in the event of liquidation, dissolution or winding up.





Holders of the Company’s Series A preferred stock have limited voting rights.





Except (1) in connection with the election of two directors to the Company’s board of directors if its dividends on the Series A preferred stock are in arrears and we have missed six quarterly dividends and (2) as otherwise required by law, holders of the Company’s Series A preferred stock have limited voting rights. In addition to any other vote or consent of shareholders required by law or the Company’s articles of incorporation, the vote or consent of holders owning at least 66 2/3% of the shares of Series A preferred stock outstanding is required for (1) any authorization or issuance of shares ranking senior to the Series A preferred stock; (2) any amendment to the rights of the Series A preferred stock that adversely affects the rights, preferences, privileges or voting power of the Series A preferred stock; or (3) consummation of any merger, share exchange or similar transaction unless the shares of Series A preferred stock remain outstanding or are converted into or exchanged for preference securities of the surviving entity other than the Company and have such rights, preferences, privileges and voting power as are not materially less favorable than those of the holders of the Series A preferred stock.





The Company’s common stock constitutes equity and is subordinate to its existing and future indebtedness and its Series A preferred stock, and effectively subordinated to all the indebtedness and other non-common equity claims against its subsidiaries.





Shares of the Company’s common stock represent equity interests in our holding company and do not constitute indebtedness. Accordingly, the shares of the Company’s common stock rank junior to all of its indebtedness and to other non-equity claims on Farmers Capital Bank




34








The Company’s right to participate in any distribution of assets of any of its subsidiaries upon the subsidiary’s liquidation or otherwise, and thus the ability of the Company’s common stock to benefit indirectly from such distribution, will be subject to the prior claims of creditors of that subsidiary.  As a result, holders of the Company’s common stock will be effectively subordinated to all existing and future liabilities and obligations of its subsidiaries, including claims of depositors.  As of December 31, 2010 our subsidiaries’ total deposits and borrowings were approximately $1.7 billion.





If the Company is unable to redeem its Series A preferred stock after an initial five-year period, the cost of this capital will increase substantially.





If the Company is unable to redeem its Series A preferred stock prior to February 15, 2014, the cost of this capital to us will increase from approximately $1.5 million annually (5.0% per annum of the Series A preferred stock liquidation value) to $2.7 million annually (9.0% per annum of the Series A preferred stock liquidation value).  This increase in the annual dividend rate on the Series A preferred stock would have a material negative effect on the earnings the Company can retain for growth and to pay dividends on its common stock.





The current economic environment exposes the Company to higher credit losses and expenses and may result in lower earnings or increase the likelihood of losses.





Although the Company remains well-capitalized, it continues to operate in a very challenging and uncertain economic environment. Financial institutions, including the Company, are being adversely effected by difficult economic conditions that have impacted not only local markets, but on a national and global scale. Substantial deterioration in real estate and other financial markets have and may continue to adversely impact the Company’s financial performance. Continuing declines in real estate values and home sales volumes, along with job losses and other economic stresses can decrease the value of collateral securing loans extended to borrowers, particularly that of real estate loans. Lower values of real estate securing loans may make it more difficult for the Company to recover amounts it is owed in the event of default by a borrower.





The current economic conditions may result in a higher degree of financial stress on the Company’s borrowers and their customers which could impair the Company’s ability to collect payments on loans, potentially increasing loan delinquencies, nonperforming assets, foreclosures, and higher losses. Current market forces have and may in the future cause the value of investment securities or other assets held by the Company to deteriorate, resulting in impairment charges, higher losses, and lower regulatory capital levels.





Market volatility could adversely impact the Company’s results of operations, liquidity position, and access to additional capital.





The capital and credit markets experienced heavy volatility and disruptions during the recent economic downturn, with unprecedented levels of volatility and disruptions that took place beginning with the last few months of 2008. In many cases, this has led to downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength. If market disruptions and volatility continue or worsen, there can be no assurance that the Company will not experience a material adverse effect on its results of operations and liquidity position or on its ability to access additional capital.





Risks associated with unpredictable economic and political conditions may be amplified as a result of limited market area.





Commercial banks and other financial institutions, including the Company, are affected by economic and political conditions, both domestic and international, and by governmental monetary policies. Conditions such as inflation, value of the dollar, recession, unemployment, high interest rates, short money supply, scarce natural resources, international disorders, terrorism and other factors beyond the Company’s control may adversely affect profitability. In addition, almost all of the Company’s primary business area is located in Central and Northern Kentucky. A significant downturn in this regional economy may result in, among other things, deterioration in the Company’s credit quality or a reduced demand for credit and may harm the financial stability of the Company’s customers. Due to the Company’s regional market area, these negative conditions may have a more noticeable effect on the Company than would be experienced by an institution with a larger, more diverse market area.





35





The Company’s results of operations are significantly affected by the ability of its borrowers to repay their loans.





Lending money is an essential part of the banking business. However, borrowers do not always repay their loans. The risk of non-payment is affected by:





·
unanticipated declines in borrower income or cash flow;


·
changes in economic and industry conditions;


·
the duration of the loan; and


·
in the case of a collateralized loan, uncertainties as to the future value of the collateral.





Due to the fact that the outstanding principal balances can be larger for commercial loans than other types of loans, such loans present a greater risk to the Company than other types of loans when non-payment by a borrower occurs.





In addition, consumer loans typically have shorter terms and lower balances with higher yields compared to real estate mortgage loans, but generally carry higher risks of frequency of default than real estate mortgage and commercial loans. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount that can be recovered on these loans.





Inability to hire or retain certain key professionals, management and staff could adversely affect the Company’s revenues and net income.





The Company relies on key personnel to manage and operate its business, including major revenue generating functions such as its loan and deposit portfolios. The loss of key staff may adversely affect the Company’s ability to maintain and manage these portfolios effectively, which could negatively affect our revenues. In addition, loss of key personnel could result in increased recruiting and hiring expenses, which could cause a decrease in our net income.





The Company’s controls and procedures may fail or be circumvented.





The Company’s management regularly reviews and updates its internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well-designed and operated, can provide only reasonable, not absolute, assurances that the objectives of the system of controls are met. Any failure or circumvention of the Company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material and adverse effect on the Company’s business, results of operations, and financial condition.





The recently enacted Dodd-Frank Act may increase the Company’s costs of operations which could adversely impact the Company's results of operations, financial condition or liquidity.





On July 21, 2010, the Dodd-Frank Act was signed into law by President Obama. The goals of the new legislation include restoring public confidence in the financial system that resulted from the recent financial and credit crises, preventing another financial crisis, and allowing regulators to identify failings in the system before another crisis can occur.  As part of the reform, the Dodd-Frank Act creates the Financial Stability Oversight Council, with oversight authority for monitoring and regulating systemic risk, and the Bureau of Consumer Financial Protection, which will have broad regulatory and enforcement powers over consumer financial products and services.  The Dodd-Frank Act also changes the responsibilities of the current federal banking regulators, imposes additional corporate governance and disclosure requirements in areas such as executive compensation and proxy access, and limits or prohibits proprietary trading and hedge fund and private equity activities of banks.





The scope of the Dodd-Frank Act impacts many aspects of the financial services industry, and requires the development and adoption of many implementing regulations over the next several months and years; consequently, the effects of the Dodd-Frank Act on the financial services industry and the Company will depend, in large part, upon the extent to which regulators exercise the authority granted to them and the approaches taken to implement the regulations.  The Company has begun to assess the potential impact of the Dodd-Frank Act on its business and operations and believes that compliance with these new laws and regulations will likely result in additional costs, but at this early stage, the probable impact cannot be predicted with a high degree of certainty. Compliance with the new laws and regulations could adversely impact the Company’s results of operations, financial condition or liquidity, any of which may impact the market price of the Company’s common stock. The Company believes that the Dodd-Frank Act will most likely impact it in the areas of corporate governance, deposit insurance assessments, capital requirements, and restrictions on fees charges to consumers.





36





Item1B. Unresolved Staff Comments





None.





Item 2. Properties





The Company, through its subsidiaries, owns or leases buildings that are used in the normal course of business. The corporate headquarters is located at 202 W. Main Street, Frankfort, Kentucky, in a building owned by the Company. The Company’s subsidiaries own or lease various other offices in the counties and cities in which they operate. See the Notes to Consolidated Financial Statements contained in Item 8, Financial Statement and Supplementary Data, of this Form 10-K for information with respect to the amounts at which bank premises and equipment are carried and commitments under long-term leases.





Unless otherwise indicated, the properties listed below are owned by the Company and its subsidiaries as of December 31, 2010.





Corporate Headquarters


202 – 208 W. Main Street, Frankfort, KY





Banking Offices125 W. Main Street, Frankfort, KY555 Versailles Road, Frankfort, KY1401 Louisville Road, Frankfort, KY154 Versailles Road, Frankfort, KY1301 US 127 South, Frankfort, KY (leased)200 E. Main Street, Georgetown, KY100 Farmers Bank Drive, Georgetown, KY (leased)100 N. Bradford Lane, Georgetown, KY3285 Main Street, Stamping Ground, KY2509 Sir Barton Way, Lexington, KY3098 Harrodsburg Road, Lexington, KY (leased)100 United Drive, Versailles, KY146 N. Locust Street, Versailles, KY206 N. Gratz, Midway, KY128 S. Main Street, Lawrenceburg, KY201 West Park Shopping Center, Lawrenceburg, KY838 N. College Street, Harrodsburg, KY1035 Ben Ali Drive, Danville, KY (leased)425 W. Dixie Avenue, Elizabethtown, KY3030 Ring Road, Elizabethtown, KY111 Towne Drive (Kroger Store) Elizabethtown, KY (leased)645 S. Dixie Blvd., Radcliff, KY4810 N. Preston Highway, Shepherdsville, KY157 Eastbrooke Court, Mt. Washington, KY103 Churchill Drive, Newport, KY7300 Alexandria Pike, Alexandria, KY164 Fairfield Avenue, Bellevue, KY8730 US Highway 42, Florence, KY34 N. Ft. Thomas Avenue, Ft. Thomas, KY2911 Alexandria Pike, Highland Heights, KY2006 Patriot Way, Independence, KY2774 Town Center Blvd., Crestview Hills, KY (leased)201 N. Main Street, Nicholasville, KY995 S. Main Street (Kroger Store), Nicholasville, KY (leased)986 N. Main Street, Nicholasville, KY106 S. Lexington Avenue, Wilmore, KY





37





Data Processing Center


102 Bypass Plaza, Frankfort, KY





Other


201 W. Main Street, Frankfort, KY





The Company considers its properties to be suitable and adequate based on its present needs.





Item 3. Legal Proceedings





As of December 31, 2010, there were various pending legal actions and proceedings against the Company arising from the normal course of business and in which claims for damages are asserted.  Management, after discussion with legal counsel, believes that these actions are without merit and that the ultimate liability resulting from these legal actions and proceedings, if any, will not have a material adverse effect upon the consolidated financial statements of the Company.





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





No matters were submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders, through the solicitation of proxies or otherwise.





PART II





Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities





At various times, the Company’s Board of Directors has authorized the purchase of shares of the Company’s outstanding common stock.  No stated expiration dates have been established under any of the previous authorizations. There were no shares of common stock repurchased by the Company during the quarter ended December 31, 2010. The maximum number of shares that may still be purchased under previously announced repurchase plans is 84,971.





On January 9, 2009, the Company received a $30.0 million equity investment by issuing 30 thousand shares of Series A, no par value preferred stock to the Treasury pursuant to a Letter Agreement and Securities Purchase Agreement that was previously disclosed by the Company. In addition, the Company issued a warrant to the Treasury allowing it to purchase 224 thousand shares of the Company’s common stock at an exercise price of $20.09. The warrant can be exercised immediately and has a term of 10 years. The Series A preferred stock and warrant were issued in a private placement exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended.





The Company’s participation in the CPP restricts its ability to repurchase its outstanding common stock.  Until January 9, 2012, the Company generally must have the Treasury’s approval before it may repurchase any of its shares of common stock, unless all of the Series A preferred stock has been redeemed by the Company or transferred by the Treasury.





Performance Graph


The following graph sets forth a comparison of the five-year cumulative total returns among the shares of Company Common Stock, the NASDAQ Composite Index ("broad market index") and Southeastern Banks under 1 Billion Market-Capitalization ("peer group index"). Cumulative shareholder return is computed by dividing the sum of the cumulative amount of dividends for the measurement period and the difference between the share price at the end and the beginning of the measurement period by the share price at the beginning of the measurement period.




38





The broad market index includes over 3,000 domestic and international based common shares listed on The NASDAQ Stock Market. The peer group index consists of 44 banking companies in the Southeastern United States. The Company is among the 44 companies included in the peer group index.










2005


2006


2007


2008


2009


2010Farmers Capital Bank Corporation

$
100.00


$
117.65


$
97.31


$
92.66


$
40.86


$
19.51NASDAQ Composite


100.00



111.74



124.67



73.77



107.12



125.93Southeastern Banks Under 1 Billion Market-Capitalization


100.00



119.54



91.33



77.91



54.70



66.90





Corporate Address


The headquarters of Farmers Capital Bank Corporation is located at:


202 West Main Street


Frankfort, Kentucky 40601





Direct correspondence to:


Farmers Capital Bank Corporation


P.O. Box 309


Frankfort, Kentucky 40602-0309


Phone: (502) 227-1668


www.farmerscapital.com




39





Annual Meeting


The annual meeting of shareholders of Farmers Capital Bank Corporation will be held Tuesday, May 10, 2011 at 11:00 a.m. at the main office of Farmers Bank & Capital Trust Company, Frankfort, Kentucky.





Form 10-K


For a free copy of Farmers Capital Bank Corporation's Annual Report on Form 10-K filed with the Securities and Exchange Commission, please write:





C. Douglas Carpenter, Executive Vice President, Secretary, and Chief Financial Officer


Farmers Capital Bank Corporation


P.O. Box 309


Frankfort, Kentucky 40602-0309


Phone:  (502) 227-1668





Web Site Access to Filings


All reports filed electronically by the Company to the United States Securities and Exchange Commission, including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports, are available at no cost on the Company’s Web site at www.farmerscapital.com.




NASDAQ Market MakersJ.J.B. Hilliard, W.L. Lyons, Inc.
Morgan, Keegan and Company(502) 588-8400
(800) 260-0280(800) 444-1854UBS Securities, LLC
Howe Barnes Hoefer & Arnett, Inc.(859) 269-6900
(800) 621-2364(502) 589-4000





The Transfer Agent and Registrar for Farmers Capital Bank Corporation is American Stock Transfer & Trust Company.





American Stock Transfer & Trust Company


Shareholder Relations


59 Maiden Lane - Plaza Level


New York, NY 10038


PH: (800) 937-5449


Fax: (718) 236-2641


Email: Info@amstock.com


Website: www.amstock.com




Additional information is set forth under the captions “Shareholder Information” and “Common Stock Price” on page 73 under Part II, Item 7 and Note 18 “Regulatory Matters” in the notes to the Company's 2010 audited consolidated financial statements on pages 105 to 108 of this Form 10-K and is hereby incorporated by reference.





40





Item 6. Selected Financial Data





Selected Financial HighlightsDecember 31,

(In thousands, except per share data)

2010


2009


2008


2007


2006Results of OperationsInterest income

$
89,751


$
100,910


$
113,920


$
114,257


$
92,340Interest expense


34,948



47,065



55,130



56,039



41,432Net interest income


54,803



53,845



58,790



58,218



50,908Provision for loan losses


17,233



20,768



5,321



3,638



965Noninterest income


34,110



28,169



9,810



24,157



20,459Noninterest expense


62,711



115,141



60,098



58,823



53,377Income (loss) from continuing operations


6,932



(44,742
)


4,395



15,627



13,665Income from discontinued operations1


















7,707Net income (loss)


6,932



(44,742
)


4,395



15,627



21,372Dividends and accretion on preferred shares


(1,871
)


(1,802
)Net income (loss) available to common shareholders


5,061



(46,544
)


4,395



15,627



21,372Per Common Share DataBasic:Income (loss) from continuing operations

$
.68


$
(6.32
)

$
.60


$
2.03


$
1.82Net income(loss)


.68



(6.32
)


.60



2.03



2.85Diluted:Income (loss) from continuing operations


.68



(6.32
)


.60



2.03



1.82Net income (loss)


.68



(6.32
)


.60



2.03



2.84Cash dividends declared


N/A



.85



1.32



1.32



1.43Book value


16.35



16.11



22.87



22.82



22.43Tangible book value2


15.87



15.44



14.81



14.43



15.81Selected RatiosPercentage of income (loss) from continuing operations to:Average shareholders’ equity (ROE)


4.55
%


(22.68
)%


2.62
%


8.88
%


8.49
%Average total assets3 (ROA)


.33



(1.98
)


.21



.83



.85Percentage of common dividends declared to income from continuing operations


N/A



N/M



220.96



64.52



78.89Percentage of average shareholders’ equity to average total assets3


7.24



8.72



7.86



9.33



10.04Total shareholders’ equity

$
149,896


$
147,227


$
168,296


$
168,491


$
177,063Total assets


1,935,693



2,171,562



2,202,167



2,068,247



1,825,108Other term borrowings and notes payable


252,209



316,932



335,661



316,309



87,992Senior perpetual preferred stock


28,719



28,348Weighted Average Common Shares OutstandingBasic


7,390



7,365



7,357



7,706



7,511Diluted


7,390



7,365



7,357



7,706



7,526


1Includes gain on disposals of $6,417 during 2006.


2Represents total common equity less intangible assets divided by the number of common shares outstanding at the end of the period.


3Excludes assets of discontinued operations in 2006.


N/A-Not applicable.


N/M-Not meaningful.




41




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





Glossary of Financial Terms




Allowance for loan losses


A valuation allowance to offset credit losses specifically identified in the loan portfolio, as well as management’s best estimate of probable incurred losses in the remainder of the portfolio at the balance sheet date.  Management estimates the allowance balance required using past loan loss experience, an assessment of the financial condition of individual borrowers, a determination of the value and adequacy of underlying collateral, the condition of the local economy, an analysis of the levels and trends of the loan portfolio, and a review of delinquent and classified loans. Actual losses could differ significantly from the amounts estimated by management.





Dividend payout


Cash dividends paid on common shares, divided by net income.





Basis points


Each basis point is equal to one hundredth of one percent.  Basis points are calculated by multiplying percentage points times 100. For example:  3.7 percentage points equals 370 basis points.





Interest rate sensitivity


The relationship between interest sensitive earning assets and interest bearing liabilities.





Net charge-offs


The amount of total loans charged off net of recoveries of loans that have been previously charged off.





Net interest income


Total interest income less total interest expense.





Net interest margin


Taxable equivalent net interest income expressed as a percentage of average earning assets.





Net interest spread


The difference between the taxable equivalent yield on earning assets and the rate paid on interest bearing funds.





Other real estate owned


Real estate not used for banking purposes. For example, real estate acquired through foreclosure.





Provision for loan losses


The charge against current income needed to maintain an adequate allowance for loan losses.





Return on average assets (ROA)


Net income (loss) divided by average total assets. Measures the relative profitability of the resources utilized by the Company.





Return on average equity (ROE)


Net income (loss) divided by average shareholders’ equity. Measures the relative profitability of the shareholders' investment in the Company.





Tax equivalent basis (TE)


Income from tax-exempt loans and investment securities have been increased by an amount equivalent to the taxes that would have been paid if this income were taxable at statutory rates. In order to provide comparisons of yields and margins for all earning assets, the interest income earned on tax-exempt assets is increased to make them fully equivalent to other taxable interest income investments.





Weighted average number of common shares outstanding


The number of shares determined by relating (a) the portion of time within a reporting period that common shares have been outstanding to (b) the total time in that period.





42





Management’s Discussion and Analysis of Financial Condition and Results of Operations





The following pages present management’s discussion and analysis of the consolidated financial condition and results of operations of Farmers Capital Bank Corporation (the “Company” or “Parent Company”), a bank holding company, and its bank and nonbank subsidiaries. Bank subsidiaries include Farmers Bank & Capital Trust Company (“Farmers Bank”) in Frankfort, KY and its significant wholly-owned subsidiaries Leasing One Corporation (“Leasing One”) and Farmers Capital Insurance Corporation (“Farmers Insurance”). Leasing One is a commercial leasing company in Frankfort, KY and Farmers Insurance is an insurance agency in Frankfort, KY. The Lawrenceburg Bank and Trust Company, which previously was a separate bank subsidiary of the Parent Company, was merged into Farmers Bank on May 8, 2010; First Citizens Bank in Elizabethtown, KY; United Bank & Trust Company (“United Bank”) in Versailles, KY which, during 2008, was the surviving company after the merger with two sister companies of Farmers Bank and Trust Company (“Farmers Georgetown”) and Citizens Bank of Jessamine County; United Bank had one subsidiary at year-end 2010, EGT Properties, Inc. EGT Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of United Bank; and Citizens Bank of Northern Kentucky, Inc. in Newport, KY (“Citizens Northern”); Citizens Northern had one subsidiary at year-end 2010, ENKY Properties, Inc. ENKY Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of Citizens Northern.





The Company has three active nonbank subsidiaries, FCB Services, Inc. (“FCB Services”), FFKT Insurance Services, Inc. (“FFKT Insurance”), and EKT Properties, Inc. (“EKT”). FCB Services is a data processing subsidiary located in Frankfort, KY that provides services to the Company’s banks as well as unaffiliated entities. FFKT Insurance is a captive property and casualty insurance company insuring primarily deductible exposures and uncovered liability related to properties of the Company. EKT was created in 2008 to manage and liquidate certain real estate properties repossessed by the Company. In addition, the Company has three subsidiaries organized as Delaware statutory trusts that are not consolidated into its financial statements. These trusts were formed for the purpose of issuing trust preferred securities. All significant intercompany transactions and balances are eliminated in consolidation.





For a complete list of the Company’s subsidiaries, please refer to the discussion under the heading “Organization” included in Part 1, Item 1 of this Form 10-K. The following discussion should be read in conjunction with the audited consolidated financial statements and related footnotes that follow.





Forward-Looking Statements


This report contains forward-looking statements with the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), under the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties.  Statements in this report that are not statements of historical fact are forward-looking statements. In general, forward-looking statements relate to a discussion of future financial results or projections, future economic performance, future operational plans and objectives, and statements regarding the underlying assumptions of such statements.  Although the Company believes that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore, there can be no assurance that the forward-looking statements included herein will prove to be accurate.





Various risks and uncertainties may cause actual results to differ materially from those indicated by the Company’s forward-looking statements. In addition to the risks described under “Item 1A Risk Factors” in this report, factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to: economic conditions (both generally and more specifically in the markets in which the Company and its subsidiaries operate) and lower interest margins; competition for the Company’s customers from other providers of financial services; deposit outflows or reduced demand for financial services and loan products; government legislation, regulation, and changes in monetary and fiscal policies (which changes from time to time and over which the Company has no control); changes in interest rates; changes in prepayment speeds of loans or investment securities; inflation; material unforeseen changes in the liquidity, results of operations, or financial condition of the Company’s customers; changes in the level of nonperforming assets and charge-offs; changes in the number of common shares outstanding; the capability of the Company to successfully enter into a definitive agreement for and close anticipated transactions; the possibility that acquired entities may not perform as well as expected; unexpected claims or litigation against the Company; technological or operational difficulties; the impact of new accounting pronouncements and changes in policies and practices that may be adopted by regulatory agencies; acts of war or terrorism; the ability of the parent company to receive dividends from its subsidiaries; the impact of larger or similar financial institutions encountering difficulties, which may adversely affect the banking industry or the Company; the Company or its subsidiary banks’ ability to maintain required capital levels and adequate funding sources and liquidity; and other risks or uncertainties detailed in the Company’s filings with the Securities and Exchange Commission, all of which are difficult to predict and many of which are beyond the control of the Company.





The Company’s forward-looking statements are based on information available at the time such statements are made. The Company expressly disclaims any intent or obligation to update any forward-looking statements to reflect changes in underlying assumptions or factors, new information, future events, or other changes.





43





Discontinued Operations


In June 2006, the Company announced that it had entered into a definitive agreement to sell Kentucky Banking Centers, Inc., its former wholly-owned subsidiary based in Glasgow, Kentucky.  In addition, Farmers Georgetown entered into a definitive agreement during August 2006 to sell its Owingsville and Sharpsburg branches in Bath County (the “Branches”).  These sales were completed during the fourth quarter of 2006.





Application of Critical Accounting Policies


The Company’s audited consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices applicable to the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility from period to period. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When third-party information is not available, valuation adjustments are estimated in good faith by management primarily through the use of internal cash flow modeling techniques.





The most significant accounting policies followed by the Company are presented in Note 1 of the Company’s 2010 audited consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes and in this management’s discussion and analysis of financial condition and results of operations, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses, fair value measurements, and accounting for goodwill to be the accounting areas that requires the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.





Allowance for Loan Losses


The allowance for loan losses represents credit losses specifically identified in the loan portfolio, as well as management's estimate of probable incurred credit losses in the loan portfolio at the balance sheet date. Determining the amount of the allowance for loan losses and the related provision for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset group on the consolidated balance sheets. Additional information related to the allowance for loan losses that describes the methodology and risk factors can be found under the captions “Asset Quality” and “Nonperforming Assets” in this management’s discussion and analysis of financial condition and results of operation, as well as Notes 1 and 4 of the Company’s 2010 audited consolidated financial statements.





Fair Value Measurements


The carrying value of certain financial assets and liabilities of the Company is impacted by the application of fair value measurements, either directly or indirectly.  Fair value is the price that would be received to sell an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. In certain cases, an asset or liability is measured and reported at fair value on a recurring basis, such as investment securities classified as available for sale.  In other cases, management must rely on estimates or judgments to determine if an asset or liability not measured at fair value warrants an impairment write-down or whether a valuation reserve should be established.





The Company estimates the fair value of a financial instrument using a variety of valuation methods. Where financial instruments are actively traded and have quoted market prices, quoted market prices are used for fair value. The Company characterizes active markets as those where transaction volumes are sufficient to provide objective pricing information, with reasonably narrow bid/ask spreads, and where received quoted prices do not vary widely. When the financial instruments are not actively traded, other observable market inputs, such as quoted prices of securities with similar characteristics, may be used, if available, to determine fair value. Inactive markets are characterized by low transaction volumes, price quotations that vary substantially among market participants, or in which minimal information is released publicly.




44




When observable market prices do not exist, the Company estimates fair value primarily by using cash flow and other financial modeling methods. The valuation methods may also consider factors such as liquidity and concentration concerns. Other factors such as model assumptions, market dislocations, and unexpected correlations can affect estimates of fair value. Changes in these underlying factors, assumptions, or estimates in any of these areas could materially impact the amount of revenue or loss recorded.





Additional information regarding fair value measurements can be found in Notes 1 and 19 of the Company’s 2010 audited consolidated financial statements.  The following is a summary of the Company’s more significant assets that may be affected by fair value measurements, as well as a brief description of the current accounting practices and valuation methodologies employed by the Company:





Available For Sale Investment Securities


Investment securities classified as available for sale are measured and reported at fair value on a recurring basis. Available for sale investment securities are valued primarily by independent third party pricing services under the market valuation approach that include, but not limited to, the following inputs:





·
U.S. Treasury securities are priced using dealer quotes from active market makers and real-time trading systems.


·
Marketable equity securities are priced utilizing real-time data feeds from active market exchanges for identical securities.


·
Government-sponsored agency debt securities, obligations of states and political subdivisions, corporate bonds, and other similar investment securities are priced with available market information through processes using benchmark yields, matrix pricing, prepayment speeds, cash flows, live trading data, and market spreads sourced from new issues, dealer quotes, and trade prices, among others sources.





At December 31, 2010, all of the Company’s available for sale investment securities were measured using observable market data.





Other Real Estate Owned


Other real estate owned (“OREO”) includes properties acquired by the Company through actual loan foreclosures and is carried at fair value less estimated costs to sell. Fair value of OREO is based on third party appraisals of the property that includes comparable sales data comprised of significant unobservable inputs. If the carrying amount of the OREO exceeds fair value less estimated costs to sell, an impairment loss is recorded through expense. At December 31, 2010 OREO was $30.5 million compared to $31.2 million at year-end 2009.





Impaired Loans


Loans are considered impaired when full payment under the contractual terms is not expected. Impaired loans are measured at the present value of expected future cash flows discounted at the loan’s effective interest rate, at the loan’s observable market price, or at the fair value of the collateral based on recent appraisals if the loan is collateral dependent. If the value of an impaired loan is less than the unpaid balance, the difference is credited to the allowance for loan losses with a corresponding charge to provision for loan losses. Loan losses are charged against the allowance for loan losses when management believes the uncollectibility of a loan is confirmed.





Appraisals used in connection with valuing collateral dependent loans may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraisers take absorption rates into consideration and adjustments are routinely made in the appraisal process to identify differences between the comparable sales and income data available. Such adjustments are usually significant and typically include significant unobservable inputs for determining fair value. Impaired loans were $130 million and $108 million at year-end 2010 and 2009, respectively.





Accounting for Goodwill


During the fourth quarter of 2009, the Company determined that its previously recorded goodwill was fully impaired and recorded a pre-tax impairment charge of $52.4 million. See Note 22 “Goodwill and Intangible Assets” of the Company’s 2010 audited consolidated financial statements for further information.





EXECUTIVE LEVEL OVERVIEW





The Company offers a variety of financial products and services at its 36 banking locations in 23 communities throughout Central and Northern Kentucky. The most significant products and services include consumer and commercial lending, receiving deposits, providing trust services, and offering other traditional banking products and services. The primary goals of the Company are to continually improve profitability and shareholder value, increase and maintain a strong capital position, provide excellent service to our customers through our community banking structure, and to provide a challenging and rewarding work environment for our employees.





The Company generates a significant amount of its revenue, cash flows, and net income from interest income and net interest income, respectively.  Interest income is generated by earnings on the Company’s earning assets, primarily loans and investment securities.  Net interest income is the excess of the interest income earned on earning assets over the interest expense paid on amounts borrowed to support those




45









Managing credit risk, or the risk of loss due to customers or other counterparties not being able to meet their financial obligations under agreed upon terms, is also a factor that can significantly influence the operating results of the Company. The severe downturn in financial markets and in the overall economy during 2008 and into 2009 created unprecedented market volatility. During that time, certain capital markets ceased to function and credit markets were unavailable to many businesses and consumers. In response, the U.S. government took extraordinary steps to stabilize financial markets by enacting broad legislation and regulatory initiatives that included the largest stimulus plan in its history. Improvement in the U.S. financial markets and the overall economy occurred during 2010. However, certain key metrics, such as high unemployment and lower real estate values persist. This has had a significant negative effect on the Company’s operations in the form of elevated nonperforming loans, allowance for loan losses, and net loan charge-offs.





Following is a summary of the more significant issues that impacted the Company during 2010 and that will continue to have an impact beyond 2010:





·
The level of nonperforming assets is currently the most important issue facing the Company. Nonperforming assets remain elevated due to a high number of borrowers that are unable to repay their loans, which has been heavily impacted by ongoing economic challenges that the Company’s borrowers and their customers face. This has resulted in lower levels of interest income, elevated levels of the provision for loans losses, and impairment charges related to properties that the Company has repossessed in an attempt to satisfy customer loan obligations.


·
Nonperforming loans and assets, although higher at year-end 2010 compared to year-end 2009, have decreased when compared to the recent high that occurred in the first quarter of 2010.


·
With the naming of Lloyd C. Hillard, Jr. as its president and chief executive officer in the first quarter of 2010, the Company has refocused its effort to establishing a culture of excellence within the organization. Initial efforts have been focused on improving the customer experience and building a strong credit culture. These initiatives have included expanded employee training and reinforcement, strengthening loan policies, and improving underwriting standards.


·
The Parent Company and its subsidiary banks that have entered into agreements with banking regulators have exceeded the capital levels required under those agreements.


·
Although the Parent Company continues to explore potential capital raising scenarios, there is currently no directive by regulators to raise any additional capital and no determination has been made as to if or when a capital raise will be completed. Net proceeds from a possible sale of securities could be used for any corporate purpose determined by the Company’s board of directors.





RESULTS OF OPERATIONS





The Company reported net income of $6.9 million or $.68 per common share in 2010 compared to a net loss of $44.7 million or $6.32 per common share for 2009. This represents an improvement of $51.7 million or $7.00 per common share. The prior year net loss was mainly attributed to a one-time $46.5 million after tax non-cash goodwill charge representing the Company’s write off of its entire previously reported goodwill.





Other significant factors impacting net income in the annual comparison include the following:





·
Net interest income increased $958 thousand or 1.8% in the year to year comparison. Interest income decreased $11.2 million or 11.1%, but was offset by lower interest expense of $12.1 million or 25.7%. The decrease in interest income was the result of lower rates and lower volume in both the loan and investment securities portfolios. The decrease in interest expense was led by a reduction in interest on deposit accounts, primarily time deposits which, decreased $10.3 million mainly due to a lower average rate paid.


·
The provision for loan losses decreased $3.5 million or 17.0% in 2010 compared to the prior year. The provision for loan losses decreased mainly because there are fewer new nonperforming and impaired loans requiring specific allocations in the current period compared to the same quarter a year ago. A decrease in loan volume contributed to a lesser extent. The Company experienced a lower rate of increase in nonperforming loans during 2010 compared to 2009. Net nonperforming loans increased $14.6 million or 19.2% in 2010. During 2009, nonperforming loans increased $50.9 million or 200%, $31.9 million of which occurred during the fourth quarter.


·
Net interest margin was 3.00% for 2010, an increase of 15 basis points from 2.85% for 2009. Net interest spread was 2.78%, up 17 basis points compared to 2.61%.


·
Noninterest income in 2010 increased $5.9 million or 21.1% due primarily to a $5.4 million increase in net gains on the sale of investment securities. Significant other favorable increases included net gains on the sale of loans of $210 thousand or 20.3%, allotment processing fees of $170 thousand or 3.1%, and non-deposit service charges, commissions, and fees of $152 thousand or 3.4%. Decreases in noninterest income line items include service charges and fees on deposits of $176 thousand or 1.9% and trust income of $75 thousand or 4.3%.


·
Total noninterest expenses decreased $52.4 million in the annual comparison. The $52.4 million goodwill impairment charge recorded in the fourth quarter of 2009 was the main driver of the improvement. All other expenses, on a net basis, were unchanged. Improvements




46




continue to be made in a significant number of noninterest expense categories. Some of the larger decreases in noninterest expense categories include salaries and employee benefits of $2.8 million or 9.4%, amortization of intangible assets of $515 thousand or 26.4%, equipment expense of $428 thousand or 13.9%, and correspondent banking fees of $391 thousand or 38.8%. Net expenses related to repossessed assets increased $4.0 million or 192%. Deposit insurance expense and bank franchise taxes were up $502 thousand or 13.3% and $217 thousand or 9.6%, respectively.


·
Income tax expense was $2.0 million for 2010 with an effective income tax rate of 22.7%. For 2009, the Company recorded an income tax benefit of $9.2 million that was driven by the impact of the goodwill impairment charge recorded during the fourth quarter. A portion of the Company’s previously recorded goodwill was created in taxable business combinations and therefore was able to record a tax benefit of $5.9 million attributed to the impairment charge.





Return on assets (“ROA”) was .33% in 2010, an increase of 231 basis points from (1.98)% for 2009. The increase in ROA is due mainly to the goodwill impairment charge that was recorded in 2009, which negatively impacted ROA in the prior year by 232 basis points. An increase in net interest margin and a lower provision for loan losses make up for 15 basis points and 10 basis points, respectively, of the increase in ROA. Higher noninterest income, mainly from investment securities gains, increased ROA by 38 basis points offset by a 49 basis point decrease attributed to income taxes. Return on equity (“ROE”) for 2010 was 4.55% compared to (22.68)% for 2009.





Interest Income


Interest income results from interest earned on earning assets, which primarily includes loans and investment securities. Interest income is affected by volume (average balance), composition of earning assets, and the related rates earned on those assets. Total interest income for 2010 was $89.8 million, a decrease of $11.2 million or 11.1% compared to $101 million for 2009. Interest income decreased across all major earning asset categories and was driven primarily by lower interest rates and, in the case for loans, a lower average volume. Rate declines were driven mainly by a combination of continuing weak economic conditions in the Company’s markets as well as the Company’s overall strategy of being more selective in pricing deposits and extending loans. Actions taken by the Federal Reserve Board has also kept the level of interest rates at near historic lows throughout 2010. In general, the Company’s variable and floating rate assets and liabilities that have reset since the prior year, as well as activity related to new earning assets and funding sources, have repriced downward to reflect the overall lower interest rate environment. The Company’s tax equivalent yield on earning assets was 4.9% for 2010, a decrease of 38 basis points compared to 5.2% for 2009.





Interest Expense


Interest expense results from incurring interest on interest bearing liabilities, which are made up of interest bearing deposits, federal funds purchased, securities sold under agreements to repurchase, and other short and long-term borrowed funds. Interest expense is affected by volume, composition of interest bearing liabilities, and the related rates paid on those liabilities. Total interest expense was $34.9 million for 2010, a decrease of $12.1 million or 25.7% compared to $47.1 million for 2009. Interest expense decreased mainly as a result of a lower average rate paid on deposits in an overall lower interest rate environment. Volume reductions, primarily on time deposits, also contributed to lower interest expense as the Company has made decisions to strategically reduce certain higher-rate deposits. The average rate paid on interest bearing liabilities was 2.1% for 2010, a decrease of 55 basis points compared to 2.6% for 2009.





The decrease in interest expense for 2010 exceeded the decrease for interest income as the Company has been able to more aggressively reduce its funding costs, particularly related to interest on deposits. The federal funds rate, which was at 4.25% at the beginning of 2008, fell to near zero percent by the end of 2008 and has remained at that level for all of 2009 and 2010. New deposits and other borrowing arrangements as well as the repricing of existing deposits and borrowings at lower market interest rates, particularly for shorter-term instruments, contributed to the overall lower interest expense in the comparable periods.





Net Interest Income


Net interest income is the most significant component of the Company’s operating earnings. Net interest income is the excess of the interest income earned on earning assets over the interest paid for funds to support those assets. The two most common metrics used to analyze net interest income are net interest spread and net interest margin.  Net interest spread represents the difference between the taxable-equivalent yields on earning assets and the rates paid on interest bearing liabilities.  Net interest margin represents the percentage of taxable equivalent net interest income to average earning assets.  Net interest margin will exceed net interest spread because of the existence of noninterest bearing sources of funds, principally demand deposits and shareholders’ equity, which are also available to fund earning assets.  Changes in net interest income and margin result from the interaction between the volume and composition of earning assets, their related yields, and the associated cost and composition of the interest bearing liabilities. Accordingly, portfolio size, composition, and the related yields earned and the average rates paid can have a significant impact on net interest spread and margin. The table following this discussion represents the major components of interest earning assets and interest bearing liabilities on a tax equivalent basis.  To compare the tax-exempt asset yields to taxable yields, amounts in the table are adjusted to pretax equivalents based on the marginal corporate Federal tax rate of 35%.





Net interest income was $54.8 million for 2010, an increase of $958 thousand or 1.8% compared to $53.8 million for 2009. Interest income for 2010 decreased $11.2 million, but was offset by a $12.1 million or 25.7% decrease in total interest expense. The Company reported a de-




47









In addition to the impact of lower overall interest rates, a decrease in volume also contributed to lower interest income on loans and interest expense on time deposits and long term borrowings. Volume decreases for loans and deposits have been largely strategy driven, whereby the Company has been more selective in pricing deposits and extending loans in a more focused effort to improve net interest margin and overall profitability. The decrease in the volume of long term borrowings were impacted by the maturity during the fourth quarter of 2010 of $50 million of borrowed funds associated with the Company’s 2007 balance sheet leverage transaction.





Tax equivalent net interest income was $57.0 million for 2010, an increase of $623 thousand or 1.1% compared to $56.4 million for 2009. The net interest margin was 3.0%, an increase of 15 basis points from 2.85% in the prior year. Net interest spread accounted for 17 basis points of the higher net interest margin and was 2.78% for 2010 compared to 2.61% for 2009. The impact of noninterest bearing sources of funds negatively impacted net interest margin by 2 basis points in the comparison.  The effect of noninterest bearing sources of funds on net interest margin typically decreases as the average cost of funds declines.





The Company continues to actively monitor and proactively manage the rate sensitive components of both its assets and liabilities in a continuously changing and difficult market environment. This task has become increasingly more difficult following the extreme market disruptions and economic downturn that began in 2008. Competition in the Company’s market areas continues to be intense. The overall interest rate environment remains low by historical measures. The Federal Reserve has kept its short-term federal funds target rate at near zero percent since mid-December 2008 and has indicated that it expects to maintain that rate at an exceptionally low level for an extended period of time. Yields on Treasury securities of medium and longer-term maturity structures have decreased as of year-end 2010 compared to a year earlier. The two and 10-year notes decreased 542 basis points and 543 basis points, respectively in the comparison while the 30-year bond dropped 307 basis points.





Similar to the short-term federal funds target rate, the prime interest rate has not changed since December 2008. The Company uses the prime interest rate as part of its pricing model primarily on variable rate commercial real estate loans. The prime interest rate can have a significant impact on the Company’s interest income on loans that reprice based on changes to the prime interest rate. The Company’s variable interest rate loans contain provisions that limit the amount of increase or decrease in the interest rate during the life of the loan. This will limit the increase or decrease in interest income on loans that have interest rates tied to the prime interest rate. For 2010, the average yield earned on loans was 5.7%, which is in excess of the prime interest rate of 3.25% at year-end 2010. Predicting the movement of future interest rates is uncertain.





During 2010, the average rates for two of the most significant components of net interest income for the Company, loans and time deposits, both declined. As previously noted, the average rate earned on the Company’s loan portfolio declined 19 basis points to 5.7% for 2010. The average rate paid on time deposits decreased 87 basis points to 2.5% in the annual comparison. Should interest rates on the Company’s earning assets and interest paying liabilities reprice lower, the Company’s yield on earning assets could potentially decrease faster than its cost of funds. Should interest rates reprice higher, the Company’s cost of funds may also increase and could continue to increase faster than the yields on earning assets, resulting in a lower net interest margin.





48





Distribution of Assets, Liabilities and Shareholders’ Equity: Interest Rates and Interest Differential


Years Ended December 31,

2010


2009


2008Average





Average


Average





Average


Average





Average(In thousands)

Balance


Interest


Rate


Balance


Interest


Rate


Balance


Interest


RateEarning AssetsInvestment securitiesTaxable

$
441,635


$
16,565



3.75
%

$
445,329


$
20,424



4.59
%

$
425,206


$
22,894



5.38
%Nontaxable1


82,327



4,149



5.04



97,960



5,186



5.29



86,784



4,653



5.36Interest bearing deposits with banks, federal funds sold and securities purchased under agreements to resell


133,586



280



.21



129,092



302



.23



65,477



1,199



1.83Loans 1,2,3


1,236,202



70,946



5.74



1,306,800



77,522



5.93



1,302,394



87,509



6.72Total earning assets


1,893,750


$
91,940



4.85
%


1,979,181


$
103,434



5.23
%


1,879,861


$
116,255



6.18
%Allowance for loan losses


(25,467
)










(18,965
)










(14,757
)Total earning assets, net of allowance for loan  losses


1,868,283











1,960,216











1,865,104Nonearning AssetsCash and due from banks


64,216











96,965











72,373Premises and equipment, net


39,541











41,069











40,649Other assets


129,618











163,804











159,228Total assets

$
2,101,658










$
2,262,054










$
2,137,354Interest Bearing LiabilitiesDepositsInterest bearing demand

$
258,674


$
453



.18
%

$
247,235


$
713



.29
%

$
256,129


$
1,805



.70
%Savings


272,080



1,663



.61



256,063



1,976



.77



261,692



3,499



1.34Time


807,730



20,257



2.51



902,066



30,508



3.38



793,561



33,741



4.25Federal funds purchased and other short-term borrowings


46,755



324



.69



62,948



453



.72



81,180



1,785



2.20Securities sold under agreements to repurchase and other long-term borrowings


304,356



12,251



4.03



331,073



13,415



4.05



330,468



14,300



4.33Total interest bearing liabilities


1,689,595


$
34,948



2.07
%


1,799,385


$
47,065



2.62
%


1,723,030


$
55,130



3.20
%Noninterest Bearing LiabilitiesCommonwealth of Kentucky deposits


1,347











34,992











37,025Other demand deposits


209,020











191,656











177,347Other liabilities


49,490











38,725











31,952Total liabilities


1,949,452











2,064,758











1,969,354Shareholders’ equity


152,206











197,296











168,000Total liabilities and shareholders’ equity

$
2,101,658










$
2,262,054










$
2,137,354Net interest income






56,992











56,369











61,125TE basis adjustment






(2,189
)










(2,524
)










(2,335
)Net interest income





$
54,803










$
53,845










$
58,790Net interest spread










2.78
%










2.61
%










2.98
%Effect of noninterest bearing sources of funds










.22











.24











.27Net interest margin










3.00
%










2.85
%










3.25
%





1Income and yield stated at a fully tax equivalent basis using the marginal corporate Federal tax rate of 35%.


2Loan balances include principal balances on nonaccrual loans.


3Loan fees included in interest income amounted to $1.4 million, $1.8 million, and $2.3 million for 2010, 2009, and 2008, respectively.




49




The following table is an analysis of the change in net interest income.





Analysis of Changes in Net Interest Income (tax equivalent basis)


Variance


Variance Attributed to


Variance


Variance Attributed to(In thousands)


2010/2009
1

Volume


Rate



2009/2008
1

Volume


RateInterest IncomeTaxable investment securities

$
(3,859
)

$
(168
)

$
(3,691
)

$
(2,470
)

$
1,036


$
(3,506
)Nontaxable investment securities2


(1,037
)


(800
)


(237
)


533



594



(61
)Interest bearing deposits with banks, federal funds sold and securities purchased under agreements to resell


(22
)


8



(30
)


(897
)


631



(1,528
)Loans2


(6,576
)


(4,128
)


(2,448
)


(9,987
)


296



(10,283
)Total interest income


(11,494
)


(5,088
)


(6,406
)


(12,821
)


2,557



(15,378
)Interest ExpenseInterest bearing demand deposits


(260
)


31



(291
)


(1,092
)


(61
)


(1,031
)Savings deposits


(313
)


117



(430
)


(1,523
)


(73
)


(1,450
)Time deposits


(10,251
)


(2,962
)


(7,289
)


(3,233
)


4,235



(7,468
)Federal funds purchased and other short-term borrowings


(129
)


(111
)


(18
)


(1,332
)


(333
)


(999
)Securities sold under agreements to repurchase and other long-term borrowings


(1,164
)


(1,097
)


(67
)


(885
)


26



(911
)Total interest expense


(12,117
)


(4,022
)


(8,095
)


(8,065
)


3,794



(11,859
)Net interest income

$
623


$
(1,066
)

$
1,689


$
(4,756
)

$
(1,237
)

$
(3,519
)Percentage change


100.0
%


(171.1
)%


271.1
%


100.0
%


26.0
%


74.0
%





1
The changes which are not solely due to rate or volume are allocated on a percentage basis using the absolute values of rate and volume variances as a basis for allocation.


2
Income stated at fully tax equivalent basis using the marginal corporate Federal tax rate of 35%.





Noninterest Income


Noninterest income for 2010 was $34.1 million, an increase of $5.9 million or 21.1% compared to $28.2 million for 2009. The increase in noninterest income was due primarily to a $5.4 million increase in net gains on the sale of investment securities. Significant other favorable increases included net gains on the sale of loans of $210 thousand or 20.3%, allotment processing fees of $170 thousand or 3.1%, non-deposit service charges, commissions, and fees of $152 thousand or 3.4%, and other income of $230 thousand or 190%. Decreases in noninterest income line items include service charges and fees on deposits of $176 thousand or 1.9% and trust income of $75 thousand or 4.3%.





The sale of investment securities in 2010 were strategically made to lock in some of the increase in their values and to  bolster capital and to help counterbalance the high level of provision for loan losses and expenses related to repossessed real estate. The sales were made after careful analysis of multiple reinvestment scenarios that would minimize the negative impact on the net interest margin on a go forward basis.





The $210 thousand increase in net gains on the sale of loans is volume related, as the amount of loans sold in 2010 were $51.5 million, up $5.6 million or 12.2% compared to 2009. The increase in loans sold is due to a higher volume of secondary market origination activity. Loan originations and refinance activities, buoyed by the low interest rate environment, picked up during the latter half of 2010 particularly in the months of October and November. The $170 thousand increase in allotment processing fees is due to overall higher transaction volumes. The increase in other non-deposit service charges, commissions, and fees of $152 thousand was driven by higher interchange fees of $220 thousand or 10.7% mainly resulting from higher transaction volumes. The $230 thousand increase in other income is mainly due to a $261 thousand lower aggregate loss attributed to tax credit partnerships. The loss attributed to these partnerships in 2010 was $145 thousand compared to a loss of $406 thousand for 2009. The aggregate carrying amount of the Company’s investment in the partnerships at year-end 2010 was $425 thousand.





The $176 thousand decrease in service charges and fees on deposits is mainly attributed to lower overdraft/insufficient funds charges of $134 thousand or 2.1%. The decrease in fees is attributed to volume declines, which led to lower fees of $124 thousand or 7.7% and $143 thousand or 8.8% during the fourth quarter of 2010 compared to the linked third quarter and fourth quarter a year ago, respectively. Beginning in the third quarter of 2010, the Federal Reserve Board began to prohibit financial institutions from charging fees to customers for paying overdrafts on one-time debit card and automated teller machine transactions without the customer opting-in to the overdraft service for those transactions. The rule change, combined with the Company’s earlier adoption during 2010 of certain regulatory “best practices” related to overdraft




50








The $75 thousand decrease in trust income is due to lower overall asset values on which trust fees are based combined with the collection of a large fee in the second quarter of the prior year.





Noninterest Expense


Total noninterest expenses were $62.7 million for 2010, a decrease of $52.4 million or 45.5% compared to $115 million for 2009. The decrease in noninterest expense in the comparison periods is mainly attributed to a $52.4 million one-time, non-cash goodwill impairment charge that was recorded in the fourth quarter of 2009. All other expenses, on a net basis, were unchanged for 2010 compared to 2009. Improvements continue to be made in a significant number of noninterest expense categories. The more significant decreases in noninterest expense categories in the comparison include salaries and employee benefits of $2.8 million or 9.4%, amortization of intangible assets of $515 thousand or 26.4%, equipment expense of $428 thousand or 13.9%, and correspondent banking fees of $391 thousand or 38.8%. Net expenses related to repossessed assets increased $4.0 million or 192%. Deposit insurance expense and bank franchise taxes were up $502 thousand or 13.3% and $217 thousand or 9.6%, respectively.





The $52.4 million goodwill impairment charge recorded in 2009 was a result of the Company’s annual goodwill impairment testing during the fourth quarter. During that testing, the Company concluded that as a result of continuing economic weaknesses and heightened market concern surrounding the credit risk and market capital position of the overall financial institutions industry, the fair value of the Company’s single reporting unit would more likely than not be below its carrying amount. The Company engaged an independent third party to assist with its goodwill impairment analysis and determined that the implied fair value of its goodwill was significantly less than the carrying value, resulting in the non-cash impairment charge.





The $2.8 million decrease in salaries and employee benefits is due to an overall shrinking workforce and a decrease in the Company’s matching contributions to its salary savings plan that took effect in the first quarter of 2010. The average number of full time equivalent employees was 528 for 2010, down 33 or 5.9% from 561 for 2009. In addition, starting in the first quarter of 2010 the Company began to match 50% of eligible employee deferrals up to a maximum of 6% of the participants’ compensation related to its salary saving plan. For 2009, the Company matched all eligible employee contributions up to 6% of the participants’ compensation.





Amortization of intangible assets, which relate to customer lists and core deposits from prior acquisitions, is decreasing as a result of amortization schedules that allocate a higher amount of amortization in the earlier periods following an acquisition consistent with how the assets are used. The $428 thousand decrease in equipment expenses for 2010 is mainly due to lower depreciation expense of $273 thousand. The decrease in depreciation expense is a result of a relatively small amount of net additions to the Company’s fixed assets. A decrease in depreciation expense on existing fixed assets exceeded the amount of depreciation expense related to net new fixed assets in the comparison. The sharp decrease in correspondent bank fees of $391 thousand are mainly a function of lower volume related to a custodial services contract with the Kentucky Teachers’ Retirement System that expired at the end of the second quarter of 2010 that was not renewed.





The $4.0 million increase in net other real estate expenses is attributed to the elevated amount of foreclosed real estate properties held by the Company during 2010. Expenses relating to these properties generally include amounts to prepare the properties for resale and, in some cases, impairment charges to write down a property’s book value to its fair value less estimated costs to sell as determined by appraisal. Impairment charges included in net other real estate expenses were $4.1 million for 2010. Three separate real estate developments account for $3.0 million of the total impairment charges.





The increase in deposit insurance expense of $502 thousand was driven mainly by higher assessment rates primarily at two of the Company’s bank subsidiaries that are subject to regulatory agreements. Deposit assessment rates fluctuate as a result of changes to a bank’s Federal Deposit Insurance Corporation’s (“FDIC”) risk category that takes into account its capital levels, supervisory ratings, and other risk measures based on various financial ratios established by the FDIC. The $217 thousand increase in bank franchise taxes correlates to an increase in the base amount subject to the Kentucky Bank Franchise Tax of the Company’s bank subsidiaries. The tax base is made up of a banks’ net capital, as defined, which generally represents the total capital of a bank adjusted for U.S. and Kentucky obligations as defined by Kentucky banking regulations.





Income Tax


Income tax expense was $2.0 million for 2010 with an effective income tax rate of 22.7%. For 2009, the Company recorded an income tax benefit of $9.2 million that was driven by the impact of the goodwill impairment charge recorded during the fourth quarter. A portion of the Company’s previously recorded goodwill was created in taxable business combinations and therefore was able to record a tax benefit of $5.9 million attributed to the impairment charge.




51


FINANCIAL CONDITION





The size of the Company’s balance sheet decreased at year-end 2010 compared to year-end 2009. The reduction is due primarily to the Company’s broad strategy to realign its balance sheet. The most significant parts of the strategy has included a more cautious and measured approach to lending as well as a more focused effort in reducing the Company’s overall cost of funds. For loans, the approach has been to be more selective, in terms of acceptable credit risk, in the credits that are underwritten. On the funding side, the approach has been to more aggressively reprice higher-rate time deposits downward as they mature or by electing to not renew. The strategy of reducing the overall size of the balance sheet is part of the Company’s plan to improve its net interest margin, nonperforming asset levels, capital ratios, and overall profitability.





Total assets were $1.9 billion at December 31, 2010, a decrease of $236 million or 10.9% from the year-end 2009. The decrease in assets occurred across all major asset groups and mainly is reflective of the balance sheet realignment strategy summarized above. The most significant decreases were as follows: cash and cash equivalents $36.3 million or 16.6%, investment securities $104 million or 18.9%, loans (net of unearned income and allowance for loan losses) $84.5 million or 6.8%, and company-owned life insurance $7.8 million or 21.4%.





The decrease in cash and cash equivalents and investment securities is attributed primarily to the overall net funding position of the Company, which was heavily influenced by the plan to lower funding costs and improve net interest margin. The decrease in investment securities has also been impacted by the overall low interest rate environment such that the Company has reinvested more of the amounts it received from maturing or called bonds into shorter term cash equivalents.





The decrease in company-owned life insurance is attributed to the liquidation of $8.6 million at the Parent Company of life insurance at its cash surrender value. The Parent Company took this action during the first quarter of 2010 mainly to have additional cash available to inject into certain of its bank subsidiaries to strengthen their capital positions. An additional $2.2 million of company-owned life insurance remains at the Parent Company at year-end 2010 that is expected to be liquidated in the near term.





Total liabilities were $1.8 billion at December 31, 2010, a decrease of $239 million or 11.8% compared to December 31, 2009. Net deposits decreased $170 million or 10.4% while net borrowed funds decreased $64.5 million or 17.7%. The net decrease in deposits was led by lower interest bearing deposits of $162 million or 11.4%. As discussed above, the decrease in interest bearing deposit balances is mainly attributed to the Company’s overall balance sheet realignment strategy and goal for reducing overall funding costs. For 2010, the Company’s average rate paid on interest bearing liabilities was 2.1%, a decrease of 55 basis points compared to 2.6% for 2009. The average rate paid on interest bearing deposits was 1.7% for 2010 or 69 basis points lower than the previous year amount of 2.4%. Lowering the cost of funds has led to a reduction of higher-balance time deposits and many of these depositors that are seeking higher yields have withdrawn their balances at maturity in lieu of renewing at lower rates.





The decrease in net borrowed funds is due to a $64.7 million or 24.2% lower amount of long-term borrowings outstanding in the year to year comparison. Long-term borrowings decreased $50.0 million as a result of scheduled maturities attributed to the Company’s 2007 balance sheet leverage transaction. The remaining decrease is nearly all attributed to scheduled repayments of Federal Home Loan Bank (“FHLB”) borrowings.





Shareholders’ equity increased $2.7 million or 1.8% to $150 million at year-end 2010 compared to $147 million a year earlier. The increase in shareholders’ equity is due mainly to net income of $6.9 million for the year partially offset by dividends on preferred stock of $1.5 million and a decrease in accumulated other comprehensive income of $3.0 million.





Management of the Company considers it noteworthy to understand the relationship between Farmers Bank and the Commonwealth of Kentucky.  Farmers Bank provides various services to state agencies of the Commonwealth.  As the depository for the Commonwealth, checks are drawn on Farmers Bank by these agencies, which include paychecks and state income tax refunds.  Farmers Bank also processes vouchers of the WIC (Women, Infants and Children) program for the Cabinet for Human Resources. Therefore, reviewing average balances is important to understanding the financial condition of the Company as daily deposit balances can fluctuate significantly as a result of Farmers Bank’s relationship with the Commonwealth.





The Commonwealth seeks qualified financial institutions to meet its banking needs by periodically issuing a request for proposal through a competitive bidding process. In a change from past practices, Farmers Bank partnered with a larger out of state financial institution to better respond to the Commonwealth’s most recent request for proposal for banking services. While the Company and the Commonwealth have had a mutually beneficial relationship in the past, the partnering concept brings greater resources to the business relationship. The Company can provide the Commonwealth with an increased level of service by partnering with the larger financial institution, leveraging off of the Company’s extensive specialized knowledge base, and maintaining local synergies. The bidding process, however, is highly competitive and there can be no assurance about whether Farmers Bank, through its partner, will continue to provide banking services to the Commonwealth in the future. The impact of not retaining the general depository services contract of the Commonwealth would not be expected to have a material impact on the Company’s results of operations, overall liquidity, or net cash flows.




52




On an average basis, total assets were $2.1 billion for 2010, a decrease of $160 million or 7.1% from the average for 2009. Average total assets decreased $52.4 million from year-end 2009 as a result of the goodwill impairment charge at year-end 2009 where the Company wrote off the entire amount of its goodwill. Average earning assets decreased $85.4 million or 4.3% from year-end 2009. However, as a percentage of total average assets, average earning assets were 90.1% for 2010, an increase of 261 basis points from 87.5% for 2009. Average net loans decreased $70.6 million or 5.4% in the comparison. Deposits averaged $1.5 billion for 2010, a decrease of $83.2 million or 5.1% from 2009. Average noninterest bearing deposit balances declined $16.3 million or 7.2% in the comparison led by a sharp decrease in amounts related to the Commonwealth of $33.6 million. All other average noninterest bearing deposits increased $17.4 million or 9.1%. Average interest bearing deposits decreased $66.9 million or 4.8% led by lower time deposits of $94.3 million or 10.5%.





Loans


Loans, net of unearned income, were $1.2 billion at December 31, 2010, a decrease of $79.1 million or 6.2% compared to year-end 2009. The Company continues to take a measured and cautious approach to loan originations while executing its balance sheet realignment strategy and working through high levels of nonperforming assets. Nonperforming assets increased sharply in the fourth quarter of 2009 and into the first quarter of 2010 as a result of the lingering effects of one of the most severe recessions in recent history. Loans secured by farmland and real estate of other commercial enterprises increased $5.6 million or 1.4% at year-end 2010 compared to year-end 2009. All other sectors of the loan portfolio experienced declines. Commercial, financial, and agricultural based lending decreased $5.7 million or 5.0%. Real estate construction and land development lending was down $57.5 million or 27.2% and loans secured by residential real estate decreased $4.4 million or .9% in the annual comparison. Consumer installment loans and commercial leasing decreased $7.7 million or 21.4% and $9.3 million or 38.4%, respectively in the yearly comparison.





The composition of the loan portfolio, net of unearned income, is summarized in the table below. Adjustments have been made among categories of prior years to reclassify certain loans to conform to their current classification. Total loans in prior years did not change.


December 31, (In thousands)

2010

%


2009

%


2008

%


2007

%


2006

%Commercial, financial, and agricultural

$
108,959


9.1
%

$
114,687


9.0
%

$
116,816


8.9
%

$
135,898


10.5
%

$
176,910


14.8
%Real estate  – construction and land development


154,208


12.9



211,725


16.7



260,434


19.8



254,788


19.7



176,779


14.8Real estate mortgage – residential


469,273


39.3



473,644


37.2



453,695


34.6



416,477


32.3



393,345


32.8Real estate mortgage – farmland and other commercial enterprises


416,904


35.0



411,309


32.3



409,909


31.2



403,167


31.2



361,004


30.1Installment


28,532


2.4



36,280


2.9



44,504


3.4



51,393


4.0



56,344


4.7Lease financing


14,964


1.3



24,297


1.9



27,222


2.1



30,262


2.3



33,454


2.8Total

$
1,192,840


100.0
%

$
1,271,942


100.0
%

$
1,312,580


100.0
%

$
1,291,985


100.0
%

$
1,197,836


100.0
%





When loan balances decline either as a result of lower demand or due to reasons such as for the Company’s plan to strategically shrink its balance sheet, the available funds are generally redirected to temporary investments or investment securities, which typically involve a decrease in credit risk and produce lower yields. The Company does not have direct exposure to the subprime mortgage market. The Company does not originate subprime mortgages nor has it invested in bonds that are secured by such mortgages. Subprime mortgage lending is defined by the Company generally as lending to a borrower that would not qualify for a mortgage loan at prevailing market rates or whereby the underwriting decision is based on limited or no documentation of the ability to repay.





On average, loans represented 65.3% of earning assets for 2010, a decrease of 75 basis points compared to 66.0% for 2009. Average loans represent a lower percentage of earning assets due to a lower average outstanding balance that has driven the overall reduction in average total earning assets.





The following table presents the amount of commercial, financial, and agricultural loans and loans secured by real estate outstanding at December 31, 2010 which, based on remaining scheduled repayments of principal, are due in the periods indicated.




53





Loan Maturities


Within


After One But


After(In thousands)

One Year


Within Five Years


Five Years


TotalCommercial, financial, and agricultural

$
43,274


$
45,474


$
20,211


$
108,959Real estate – construction and land development


124,682



23,569



5,957



154,208Real estate mortgage – residential


69,263



109,260



290,750



469,273Real estate mortgage – farmland and other commercial enterprises


77,387



189,897



149,620



416,904Total

$
314,606


$
368,200


$
466,538


$
1,149,344





The table below presents the amount of commercial, financial, and agricultural loans and loans secured by real estate outstanding at December 31, 2010 that are due after one year, classified according to sensitivity to changes in interest rates.





Interest Sensitivity


Fixed


Variable(In thousands)

Rate


RateDue after one but within five years

$
289,718


$
78,482Due after five years


59,819



406,719Total

$
349,537


$
485,201





Asset Quality


The Company’s loan portfolio is subject to varying degrees of credit risk. Credit risk is mitigated by diversification within the portfolio, limiting exposure to any single customer or industry, rigorous lending policies and underwriting criteria, and collateral requirements. The Company maintains policies and procedures to ensure that the granting of credit is done in a sound and consistent manner. This includes policies on a company-wide basis that require certain minimum standards to be maintained. However, the policies also permit the individual subsidiary companies authority to adopt standards that are no less stringent than those included in the company-wide policies. Credit decisions are made at the subsidiary bank level under guidelines established by policy. The Company’s internal audit department performs loan reviews at each subsidiary bank during the year. This loan review evaluates loan administration, credit quality, documentation, compliance with Company loan standards, and the adequacy of the allowance for loan losses on a consolidated and subsidiary basis.





The provision for loan losses represents charges made to earnings to maintain an allowance for loan losses at an adequate level based on credit losses specifically identified in the loan portfolio, as well as management’s best estimate of probable incurred loan losses in the remainder of the portfolio at the balance sheet date. The allowance for loan losses is a valuation allowance increased by the provision for loan losses and decreased by net charge-offs. Loan losses are charged against the allowance when management believes the uncollectibility of a loan is confirmed. Subsequent recoveries, if any, are credited to the allowance.





Management estimates the allowance balance required using a risk-rated methodology. Many factors are considered when estimating the allowance. These include, but are not limited to, past loan loss experience, an assessment of the financial condition of individual borrowers, a determination of the value and adequacy of underlying collateral, the condition of the local economy, an analysis of the levels and trends of the loan portfolio, and a review of delinquent and classified loans. The allowance for loan losses 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 risk factors. 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. Actual loan losses could differ significantly from the amounts estimated by management.





The risk-rated methodology includes segregating watch list and past due loans from the general portfolio and allocating specific reserves to these loans depending on their status. For example, watch list loans, which may be identified by the internal loan review risk-rating process or by regulatory examiner classification, are assigned a certain loss percentage while loans past due 30 days or more are assigned a different loss percentage. Each of these percentages considers past experience as well as current factors. The remainder of the general loan portfolio is segregated into three components having similar risk characteristics as follows: commercial loans, consumer loans, and real estate loans. Each of these components is assigned a loss percentage based on their respective rolling twelve quarter historical loss percentage. Additional allocations to the allowance may then be made for subjective factors, such as those mentioned above, as determined by senior managers who are knowledgeable about these matters. During 2007, the Company further identified signs of deterioration in certain real estate development loans that have remained present into 2010 and specific allowances related to these loans were recorded.




54




While management considers the allowance for loan losses to be adequate based on the information currently available, additional adjustments to the allowance may be necessary due to changes in the factors noted above. Borrowers may experience difficulty in periods of economic deterioration, and the level of nonperforming loans, charge-offs, and delinquencies could rise and require additional increases in the provision for loan losses. Regulatory agencies, as an integral part of their examinations, periodically review the allowance for loan losses. These reviews could result in additional adjustments to the provision for loan losses based upon their judgments about relevant information available during their examination.





In general, allowance for loan losses increases as the level of nonperforming and impaired loans, as a percentage of net loans outstanding, increases. The Company’s allowance for loan loss amount has heavily considered past loan loss experience to estimate current loan losses, but it also considers current trends within the portfolio that may not be indicative of past charge-off levels. Adjustments are made to the allowance for loan losses as needed when such matters are identified.




Although there were signs of improvements during 2010, economic weaknesses remain as a result of one of the most severe economic declines in recent history which began in the latter part of 2007 and early 2008. These economic conditions resulted in significant stress through deterioration in credit quality and collateral values, primarily in the Company’s residential real estate development and commercial real estate sectors of its lending portfolio. Lower real estate values, increased foreclosures, and high levels of unemployment over a prolonged period have all contributed to the Company’s elevated amounts of nonperforming assets and loan charge-offs. These factors have also resulted in an increase in the allowance for loan losses primarily related to real estate development and commercial real estate lending. Real estate markets, both residential and commercial, remain strained and unemployment rates are forecasted to remain high for the foreseeable future. A slowdown in real estate sales activity creates cash flow difficulties for those borrowers in real estate development and related businesses that primarily depend on the sale of real estate. The Company expects the lingering effects of the economic downturn to continue to hinder its efforts to improve asset quality in the short term. The Company works with its loan customers on an individual case-by-case basis in order to maximize loan repayments and does not have a formal loan modification program.





Impaired loans are defined as loans in which the Company does not expect to receive full payment under the contractual terms. Impaired loans are measured at the present value of expected future cash flows discounted at the loan’s effective interest rate, at the loan’s observable market price, or at the fair value of the collateral taking into consideration estimated costs to sell if the loan is collateral dependent. Collateral values are updated in accordance with policy guidelines by  obtaining independent third party appraisals and monitoring sales activity of similar properties in our market area.





Following is a tabular presentation of impaired loans at December 31, 2010 that includes the loan type, unpaid principal balance, estimated collateral value, and type of collateral for significant groupings of loans:


(In thousands)



Loan Type

Unpaid

Principal


Estimated

Collateral

Value

Collateral TypeReal estate-construction and land development

$
58,750


$
79,954

Primarily residential real estate developmentsReal estate mortgage-residential


33,045



48,286

Residential real estate, including single and multi-family useReal estate mortgage-farmland and other commercial enterprises


37,674



61,642

Commercial real estate, including farmland and other business enterprisesOther


551



235

Business assets, inventory, accounts receivable, personal autos, and other vehiclesTotal

$
130,020


$
190,117





In the aggregate, the estimated collateral value for impaired loans exceeds the unpaid principal amount. In many cases the estimated fair value of the collateral less cost to sell exceeds the loan balance and no impairment reserve is needed. However, the Company has taken a charge to write down certain of these impaired loans to the estimated fair value of the collateral (less estimated costs to sell). At year-end 2010, the Company had $6.0 million in specific reserves related to its impaired loans. Of this total, $2.8 million or 46.3% is attributed to real estate construction and land development lending and $2.1 million or 34.0% is attributed to loans secured by residential real estate. Two individual credit relationships account for $3.3 million or 54.5% of the $6.0 million specific reserves. Both of these credits have been restructured and have an aggregate outstanding principal balance of $10.3 million.





The provision for loan losses was $17.2 million for 2010, a decrease of $3.5 million or 17.0% compared to $20.8 million for 2009. The decrease in the provision for loan losses for 2010 is mainly due to fewer new nonperforming and impaired loans requiring specific allocations compared to a year earlier. An overall net decrease in loans outstanding contributed, to a lesser extent, to the lower provision for loan losses. The Company experienced a lower rate of increase in nonperforming loans during 2010 compared to 2009. Nonperforming loans were $91.0 million at year-end 2010, representing an increase of $14.6 million over the prior year. For 2009, the increase in nonperforming loans was




55




“Nonperforming Assets”




Net loan charge-offs were $11.8 million for 2010, a decrease of $2.4 million or 17.0% compared to $14.2 million for 2009. Charge-offs of $5.4 million or 45.8% of total charge-offs for 2010 are attributed to four individual credit relationships that represent primarily residential real estate development projects. Gross charge-offs and recoveries by loan category are detailed in the table that follows. Net charge-offs as a percentage of average loans were .96% for 2010, a decrease of 13 basis points compared to 1.09% for 2009. Although the provision for loan losses was lower in 2010 compared to the year before, the allowance for loan losses as a percentage of outstanding loans (net of unearned income) has increased to 2.41% at December 31, 2010 compared to 1.84% at December 31, 2009. The allowance for loan losses as a percentage of nonperforming loans was 31.6% and 30.6% at year-end 2010 and 2009, respectively.





The relatively low percentage of the allowance for loan losses to nonperforming loans is due in part to the composition of nonperforming loans. Restructured loans account for 40.6% of the total amount of nonperforming loans at year-end 2010. The allowance attributed to credits that are restructured with lower interest rates represents the difference in the present value of future cash flows calculated at the loan’s original effective interest rate and the new lower rate. This generally results in a reserve for loan losses that is less severe than for other loans that are collateral dependent.





In addition to higher restructured loans, nonaccrual loans at year-end 2010 include an aggregate amount of $19.0 million higher-balance loans representing five credit relationships that had specific reserves of $1.1 million prior to being classified as nonaccrual. The classification of these loans to nonaccrual status had a more limited impact on the allowance for loan losses since a reserve had already been established. Each of these loans were performing at year-end 2009, but were identified as impaired on that date and specific reserves were recorded. From this group of credits, loans totaling $16.0 million are secured primarily by real estate construction and land development projects and $3.0 million secured mainly by residential real estate properties.





The table below summarizes the loan loss experience for the past five years. Reclassifications have been made between categories of charge offs and recoveries in prior years in order to conform to current loan classifications. Total charge offs and recoveries in prior years did not change.





Allowance For Loan Losses


Years Ended December 31, (In thousands)

2010


2009


2008


2007


2006Balance of allowance for loan losses at beginning of year

$
23,364


$
16,828


$
14,216


$
11,999


$
11,069Acquisition of Citizens Jessamine


















1,066Loans charged off:Commercial, financial, and agricultural


869



1,618



1,160



618



562Real estate-construction and land development


7,599



4,176



581



9Real estate mortgage-residential


1,521



3,247



675



395



66Real estate mortgage-farmland and other commercial enterprises


1,557



2,304



817



258



134Installment loans to individuals


709



948



953



822



763Lease financing


135



2,475



356



52



254Total loans charged off


12,390



14,768



4,542



2,154



1,779Recoveries of loans previously charged off:Commercial, financial, and agricultural


181



132



153



186



307Real estate-construction and land development


2







8



5Real estate mortgage-residential


42



82



53



82



43Real estate mortgage-farmland and other commercial enterprises


28



34



991



153



38Installment loans to individuals


286



216



256



260



249Lease financing


38



72



372



47



41Total recoveries


577



536



1,833



733



678Net loans charged off


11,813



14,232



2,709



1,421



1,101Additions to allowance charged to expense


17,233



20,768



5,321



3,638



965Balance at end of year

$
28,784


$
23,364


$
16,828


$
14,216


$
11,999Average loans net of unearned income

$
1,236,202


$
1,306,800


$
1,302,394


$
1,250,423


$
1,051,002Ratio of net charge-offs  during year to average loans, net of unearned income


.96
%


1.09
%


.21
%


.11
%


.10
%





56





The following table presents an estimate of the allocation of the allowance for loan losses by type for the date indicated. Although specific allocations exist, the entire allowance is available to absorb losses in any particular category. Adjustments have been made between categories of prior years related to classification changes of certain loans to conform to their current presentation. The total allowance for loan losses in previous years did not change.


December 31, (In thousands)

2010


2009


2008


2007


2006Amount


% of Respective Loan Category


Amount


% of Respective Loan Category


Amount


% of Respective Loan Category


Amount


% of Respective Loan Category


Amount


% of Respective Loan CategoryCommercial, financial, and agricultural

$
2,876



2.6
%

$
3,914



3.41
%

$
1,992



1.71
%

$
2,315



1.70
%

$
2,091



1.18
%Real estate – construction and land development


10,367



6.7



9,806



4.63



5,065



1.94



3,902



1.53



1,981



1.12Real estate mortgage – residential


10,017



2.1



4,749



1.00



3,337



.74



3,146



.76



2,989



.76Real estate mortgage – farmland and other commercial enterprises


4,143



1.0



3,252



.79



3,300



.81



2,347



.58



1,684



.47Installment loans to individuals


997



3.5



1,005



2.77



2,333



5.24



1,975



3.84



2,291



4.07Lease financing


384



2.6



638



2.63



801



2.94



531



1.75



963



2.88Total

$
28,784



2.41
%

$
23,364



1.84
%

$
16,828



1.28
%

$
14,216



1.10
%

$
11,999



1.00
%





In addition to the discussion above relating to lending activities, additional information concerning the Company’s asset quality is discussed under the caption “Nonperforming Assets” which follows and “Investment Securities” beginning on page 60.





Nonperforming Assets


Nonperforming assets for the Company include nonperforming loans, other real estate owned, and other foreclosed assets. Nonperforming loans consist of nonaccrual loans, restructured loans, and loans 90 days or more past due and still accruing interest.  In general, the accrual of interest on loans is discontinued when it is determined that the collection of interest or principal is doubtful, or when a default of interest or principal has existed for 90 days or more, unless such loan is well secured and in the process of collection. Restructured loans occur when a lender, because of economic or legal reasons related to a borrower’s financial difficulty, grants a concession to the borrower that it would not otherwise consider. Restructured loans typically include a reduction of the stated interest rate or an extension of the maturity date, among other possible concessions. For the Company, all of its restructured loans were granted rate concessions at the time of restructuring.





Nonperforming assets were $122 million at December 31, 2010, an increase of $14.0 million or 13.0% compared to $108 million at year-end 2009. Nonperforming assets spiked upward by $67.7 million or 169% in the prior year and have remained elevated mainly as a result of the ongoing weaknesses in the overall economy that continues to strain the Company and many of its customers, particularly those associated with real estate development lending. The increase in nonperforming assets for 2010 compared to 2009 is primarily attributed to higher restructured loans of $19.1 million or 106%.





Nonperforming assets by category are presented in the table below for the dates indicated.


December 31, (In thousands)

2010


2009


2008


2007


2006Loans accounted for on nonaccrual basis

$
53,971


$
56,630


$
21,545


$
18,073


$
1,462Loans past due 90 days or more and still accruing


42



1,807



3,913



2,977



2,856Restructured loans


36,978



17,911Total nonperforming loans


90,991



76,348



25,458



21,050



4,318Other real estate owned


30,545



31,232



14,446



6,044



5,031Other foreclosed assets


34



38



47



66



54Total nonperforming assets

$
121,570


$
107,618


$
39,951


$
27,160


$
9,403





57





Additional details for nonperforming loans were as follows at year-end 2010 and 2009:





Nonperforming Loans


December 31, (In thousands)

2010


2009Nonaccrual LoansCommercial, financial, and agriculture

$
658


$
965Real estate-construction and land development


35,893



35,648Real estate mortgage-residential


10,728



8,633Real estate mortgage-farmland and other commercial enterprises


6,528



11,038Installment


114



241Lease financing


50



105Total nonaccrual loans

$
53,971


$
56,630Restructured LoansCommercial, financial, and agriculture





$
670Real estate-construction and land development

$
16,793



11,047Real estate mortgage-residential


9,147



2,053Real estate mortgage-farmland and other commercial enterprises


11,038



4,141Total restructured loans

$
36,978


$
17,911Past Due 90 Days or More and Still AccruingCommercial, financial, and agriculture





$
450Real estate-construction






477Real estate mortgage-residential

$
28



458Real estate mortgage-farmland and other commercial enterprises






27Installment


5



395Lease financing


9Total past due 90 days or more and still accruing

$
42


$
1,807Total nonperforming loans

$
90,991


$
76,348Ratio of total nonperforming loans to total loans (net of unearned income)


7.6
%


6.0
%





Nonaccrual loans make up the largest component of nonperforming assets. Such loans were $54.0 million at December 31, 2010, a decrease of $2.7 million or 4.7% compared to $56.6 million at year-end 2009. Three of the Company’s four subsidiary banks experienced an overall net decrease in nonaccrual loans of $8.8 million or 23.3% in the annual comparison. This was partially offset by a $6.1 million or 32.3% increase at one of the Company’s subsidiary banks due mainly to the addition of three credit relationships amounting to $7.2 million. Of these three credits, two in the amount of $4.2 million in the aggregate were identified as impaired during 2009 and specific reserves were allocated. A third credit in the amount of $3.0 million, with a specific reserve allocation of $196 thousand, was added during the fourth quarter of 2010.





The $19.1 million net increase in restructured loans at year-end 2010 compared to year-end 2009 was led by a residential real estate development credit in the amount of $9.7 million and three other separate credits totaling $8.1 million. Of the three credits totaling $8.1 million, one relates to a credit relationship with an outstanding total of $3.8 million secured by vacation condo units and the other two represent $4.3 million in the aggregate secured by commercial real estate properties. The Company gives careful consideration to identifying which of its challenged credits merit a restructuring of terms that it believes will result in maximum loan repayments and mitigate possible losses. Cash flow projections are carefully scrutinized prior to restructuring any credits; past due credits are typically not granted concessions.





From time to time the Company’s affiliate banks modify a customer’s loan, but such modifications may not meet the criteria for classification of restructured troubled debt.  The primary reasons for such restructurings are:





·
repricing a loan to a current market rate of interest to a borrower with good credit and adequate collateral value in order to retain the customer,


·
changing the payment frequency from monthly to quarterly, semi-annually, or annually where the loan is performing, the borrower has good credit and adequate collateral value and the Company believes valid reasons exist for the change, or


·
extending the interest only payment period of a performing loan where the borrower has good credit and adequate collateral value in instances where a project may still be in a phase of development or leasing-up, but where the Company believes completion will occur in the near future, or such extension is otherwise in the Company’s best interest.





58





As a modification is made, management evaluates whether the modification meets the criteria to be classified as a troubled debt.  This criteria has two components:





1.
The bank made a concession on the loan terms, and


2.
The borrower is experiencing financial difficulty.





The Company’s loan policy has been recently updated to provide guidance to lending personnel as a result of the recent increase in restructured loans to ensure those that are troubled debt are properly categorized. Additional attention is being given to restructured loans through the oversight of the recently established position of Chief Credit Officer at the parent company to ensure that modifications meeting criteria for restructured loans are identified and properly reported.





The table below sets forth on an aggregate basis at December 31, 2010, the types of non-troubled debt restructurings by loan type, number of loans, average loan balance and modification type:


# of

Loans

Loan Type

Average Loan

Balance

(in thousands)


Range of

Loan Balances

(in thousands)

Modification Type1

Commercial, financial and agricultural


$13



N/A

changed repayment frequency56

Commercial, financial and agricultural


39



$0 - $470

lowered interest rate to market rate to retain loan26

Installment loan


16



1 - 67

lowered interest rate to market rate to retain loan2

Installment loan


4



3 - 6

changed repayment frequency42

Real estate mortgage – farmland and other commercial enterprises


650



0 - 4,530

lowered interest rate to market rate to retain loan4

Real estate mortgage – farmland and other commercial enterprises


1,412



1 - 2,919

changed repayment frequency or extended interest only period68

Real estate mortgage - residential


194



7 - 5,135

lowered interest rate to market to retain loan (in one case increased payment frequency)11

Real estate mortgage - residential


122



74 - 193

changed repayment frequency (in one case modified payment terms for estates of deceased borrower at representative’s request)15

Real estate – construction and land development


184



13 - 741

lowered interest rate to market rate to retain loan (in two cases extended interest only period)





In each of the loan modifications identified in the table, management of the applicable bank determined the loan was not in troubled condition due to the financial status of the borrower and collateral.





The Company’s subsidiary banks have not engaged in loan splitting. Loan splitting is a practice that may occur in work-out situations whereby a loan is divided into two parts – a performing part and a nonperforming part. This benefits a lender by potentially replacing one impaired loan by one smaller good loan and one smaller bad loan. Overall charge-offs and reserve amounts are potentially reduced and the effects of adverse loan classifications may be diminished.





Other real estate owned (“OREO”) was $30.5 million at year-end 2010, a decrease of $687 thousand or 2.2% compared to $31.2 million at year-end 2009. Real estate properties totaling $17.8 million were transferred into OREO during 2010, offset primarily by sales and write-downs of OREO totaling $14.4 million and $4.1 million, respectively. The $17.8 million transferred into OREO during 2010 is made up mostly by real estate securing eight credit relationships totaling $10.2 million, which includes $8.8 million classified as nonaccrual at year-end 2009. Of the $14.4 million sold in 2010, $8.6 million represents the five largest amounts in terms of carrying values, the largest of which relates to a single commercial property of $4.6 million sold during the first quarter.




59





The Company’s comprehensive risk-grading and loan review program includes a review of loans to assess risk and assign a grade to those loans, a review of delinquencies, and an assessment of loans for needed charge-offs or placement on nonaccrual status. The Company had loans in the amount of $127 million and $105 million at year-end 2010 and year-end 2009, respectively, which were performing but considered potential problem loans and are not included in the nonperforming loan totals in the table above. These loans, however, are considered in establishing an appropriate allowance for loan losses. The balance outstanding for potential problem credits is mainly a result of ongoing weaknesses in the overall economy that continue to strain the Company and many of its customers, particularly real estate development lending. Potential problem loans include a variety of borrowers and are secured primarily by real estate. At December 31, 2010 the five largest potential problem credits were $35.9 million in the aggregate compared to $31.4 million at year-end 2009 and secured by various types of real estate including commercial, construction properties, and residential real estate development.





Potential problem loans are identified on the Company’s watch list and consist of loans that require close monitoring by management. Credits may be considered as a potential problem loan for reasons that are temporary or correctable, such as for a deficiency in loan documentation or absence of current financial statements of the borrower. Potential problem loans may also include credits where adverse circumstances are identified that may affect the borrower’s ability to comply with the contractual terms of the loan. Other factors which might indicate the existence of a potential problem loan include the delinquency of a scheduled loan payment, deterioration in a borrower’s financial condition identified in a review of periodic financial statements, a decrease in the value of the collateral securing the loan, or a change in the economic environment in which the borrower operates. Certain loans on the Company’s watch list are also considered impaired and specific allowances related to these loans were established in accordance with the appropriate accounting guidance.





Temporary Investments


Temporary investments consist of interest bearing deposits in other banks and federal funds sold and securities purchased under agreements to resell. The Company uses these funds in the management of liquidity and interest rate sensitivity. At December 31, 2010, temporary investments were $158 million, a decrease of $24.7 million or 13.5% compared to $182 million at year-end 2009. The decrease in temporary investments was driven by lower interest bearing deposit balances held in other banks of $36.0 million or 20.5%, primarily with the Federal Reserve banking system, partially offset by a $11.3 million or 172% increase in federal funds sold and securities purchased under agreements to resell.





Temporary investments averaged $134 million for the year 2010, an increase of $4.5 million or 3.5% compared to $129 million from year-end 2009. The increase is a result of the Company’s overall net funding position, which reflects a more conservative lending approach as the Company works through its high level of nonperforming assets and a continuing difficult economy. Temporary investments are reallocated to loans or other investments as market conditions and Company resources warrant.





Investment Securities


The investment securities portfolio is comprised primarily of debt securities issued by U.S. government-sponsored agencies, mortgage-backed securities, and tax-exempt securities of states and political subdivisions. Substantially all of the Company’s investment securities are designated as available for sale. Total investment securities were $445 million on December 31, 2010, a decrease of $104 million or 18.9% compared to $549 million at year-end 2009. Net amortized cost amounts decreased $97.3 million or 18.1%. Net unrealized gains related to investments in the available for sale portfolio decreased $6.4 million or 64.0%.





The decrease in amortized cost amounts of investment securities for 2010 is attributed primarily to net sales activity, along with maturing and called securities that have outpaced purchases. During 2010 the Company sold $311 million of available for sale investment securities at a net gain of $8.9 million. The sale of investment securities was part of an overall strategy to realign the balance sheet and to lock in some of the increase in the value of securities, strengthen capital, and to help counterbalance the high level of provision for loan losses and expenses related to repossessed real estate. The sales were made after careful analysis of multiple reinvestment scenarios to minimize the negative impact on the net interest margin on a go forward basis. The decrease in investment securities was also impacted by the Company’s 2007 balance sheet leverage transaction. During 2010, $50 million of borrowings attributed to the leverage transaction matured and certain maturing bonds were used to fund the payoff of the borrowing rather than being reinvested in investment securities.





The $6.4 million overall decrease in the net unrealized gains for available for sale investment securities is attributed mainly to the volume of securities sold during 2010. As previously discussed, the Company in 2010 sold investment securities to lock in some of their increase in the value to strengthen capital and help counterbalance the high level of provision for loan losses and expenses related to repossessed real estate. A portion of the previously recorded net unrealized gain on investments sold was realized in income at the time of sale.





Included in the sale of investment securities in 2010 were $12.1 million amortized costs amount of corporate debt securities sold during the second quarter at a net loss of $168 thousand. An additional $1.0 million of corporate debt securities matured in the second quarter of 2010. The debt securities sold, although still rated as investment grade, were downgraded during 2009 and sold after a careful analysis of their short and long-term prospects determined they no longer suited the Company’s investment preferences.




60





At year-end 2010, the Company holds $5.8 million amortized cost amounts of single-issuer trust preferred capital securities of a global financial services firm with an estimated fair value of $5.0 million. These securities had an estimated fair value of $4.4 million at year-end 2009. These securities continue to perform according to contractual terms and the issuer of these securities is rated as investment grade by major rating agencies. The Company does not intend to sell these securities nor does the Company believe it is likely that it will be required to sell these securities prior to their anticipated recovery. The Company believes these securities are not impaired due to reasons of credit quality or other factors, but rather the unrealized loss is primarily attributed to the decline in the financial markets and market volatility that occurred during 2008 and has not fully stabilized. Gradual improvements in many economic measures have resulted in higher market values of these securities in 2010. The Company believes that it will be able to collect all amounts due according to the contractual terms of these securities and that the fair values of these securities will recover as they approach their maturity dates.





Gross unrealized losses totaling $5.0 million at December 31, 2010 within the Company’s investment securities portfolio have not been included in income since they are identified as temporary. The Company believes that it will be able to collect all amounts due according to the contractual terms of these securities and that the fair values of these securities will recover as they approach their maturity dates. The Company does not consider any of the securities to be impaired due to reasons of credit quality or other factors. The Company does not expect to incur a loss on these securities unless they are sold prior to maturity. The Company does not currently have the intent to sell nor does it believe it will be required to sell these securities before anticipated recovery. All investment securities in the Company’s portfolio are currently performing.





Funds made available from sold, maturing or called bonds are redirected to fund higher yielding loan growth, reinvested to purchase additional investment securities, or otherwise employed to improve the composition of the balance sheet. The purchase of nontaxable obligations of states and political subdivisions is one of the primary means of managing the Company’s tax position. The impact of the alternative minimum tax related to the Company’s ability to acquire tax-free obligations at an attractive yield is routinely monitored. The Company does not have direct exposure to the subprime mortgage market. The Company does not originate subprime mortgages nor has it invested in bonds that are secured by such mortgages.





The following table summarizes the carrying values of investment securities on December 31, 2010, 2009, and 2008.  The investment securities are divided into available for sale and held to maturity securities.  Available for sale securities are carried at the estimated fair value and held to maturity securities are carried at amortized cost. Corporate debt securities consist primarily of debt issued by a large global financial services firm. Equity securities are attributed to the Company’s captive insurance subsidiary.


December 31,

2010


2009


2008(In thousands)

Available

for Sale


Held to

Maturity


Available

for Sale


Held to

Maturity


Available

for Sale


Held to

MaturityObligations of states and political subdivisions

$
74,799


$
930


$
108,958


$
975


$
90,838


$
1,814Obligations of U.S. government-sponsored entities


41,613







90,752







34,567Mortgage-backed securities – residential


319,930







325,519







375,327U.S. Treasury securities


1,044







3,002







10,256Money market mutual funds


145







910







374Corporate debt securities


6,606







18,732







13,991Equity securities


45Total

$
444,182


$
930


$
547,873


$
975


$
525,353


$
1,814





The following table presents an analysis of the contractual maturity and tax equivalent weighted average interest rates of investment securities at December 31, 2010. Available for sale securities amounts are stated at fair value and held to maturity securities amounts are stated at amortized cost. Equity securities in the available for sale portfolio are attributed to the Company’s captive insurance subsidiary, which have no stated maturity and are not included in the maturity schedule that follows.




61





Available for Sale


After One But


After Five ButWithin One Year


Within Five Years


Within Ten Years


After Ten Years(In thousands)

Amount

Rate


Amount

Rate


Amount

Rate


Amount

RateObligations of U.S. government-sponsored entities

$
257


2.6
%

$
24,201


1.2
%

$
17,155


2.1
%Obligations of states and political subdivisions


5,629


2.9



23,540


2.9



29,734


3.5


$
15,895


3.7
%Mortgage-backed securities – residential









1,828


4.9



2,788


2.6



315,314


3.6
%U.S. Treasury securities


1,044


.9Money market mutual funds


145


.2Corporate debt securities


609


5.9



905


5.8



104


5.5



4,989


2.0Total

$
7,684


2.8
%

$
50,474


2.2
%

$
49,781


2.9
%

$
336,198


3.6
%





Held to Maturity


After One But
After Five ButWithin One Year
Within Five Years
Within Ten Years

After Ten Years(In thousands)
Amount
Rate
Amount
Rate
Amount
Rate

Amount


RateObligations of states and political subdivisions







$
844



3.6
%





The calculation of the weighted average interest rates for each category is based on the weighted average costs of the securities. The weighted average tax rates on exempt states and political subdivisions are computed based on the marginal corporate Federal tax rate of 35%.





Deposits


The Company’s primary source of funding for its lending and investment activities results from its customer deposits, which consist of noninterest and interest bearing demand, savings, and time deposits. On December 31, 2010 total deposits were $1.5 billion, a decrease of $170 million or 10.4% from year-end 2009.  Both noninterest bearing and interest bearing deposits declined in the comparison. Noninterest bearing deposits decreased $7.6 million or 3.6% due to a $12.8 million or 95.2% lower balance from the Commonwealth of Kentucky. All other noninterest deposits increased $5.2 million or 2.6%. Interest bearing deposit balances decreased $162 million or 11.4%, led by lower time deposits outstanding of $191 million or 21.1% partially offset by higher savings account balances of $24.5 million or 9.5%.





On an average basis, total deposits were $1.5 billion for 2010, a decrease of $83.2 million or 5.1% compared to 2009. Average noninterest bearing deposits decreased $16.3 million or 7.2%, led by lower deposits from the Commonwealth of $33.6 million or 96.2%. All other noninterest bearing deposits, on average, increased $17.4 million or 9.1%. Average interest bearing deposits decreased $66.9 million or 4.8% year over year due to lower time deposits of $94.3 million or 10.5% partially offset by an increase of $16.0 million or 6.3% in savings deposit balances and higher interest bearing demand deposits of $11.4 million or 4.6%.





The decrease in both the end of period and average balances of the Commonwealth is due mainly to a data processing change by the Company during the first quarter of 2010. This change resulted in deposit transmissions from the Commonwealth that are generally received and credited after processing deadlines for same day credit. Although deposits from the Commonwealth can fluctuate significantly from day to day, outstanding balances are expected to remain at lower than recent historical levels as a result of the data processing change.





The sharp declines in the end of period and average time deposits for 2010 compared to year-end 2009 is due in part to the maturity structure of the portfolio and the Company’s overall strategy of realigning and reducing the size of its balance sheet. The Company’s liquidity position has enabled it to lower its cost of funds by more aggressively repricing higher-rate maturing certificates of deposit downward in an overall lower interest rate environment or by allowing them to roll off without renewing. Rate offerings on new deposits have also had an overall decline due to the low rate environment. The Company has not sought out or accepted brokered deposits in the past nor does it have plans to do so in the future.




62





A summary of average balances for deposits by type and the related weighted average rates paid are as follows for the periods presented:


Years Ended December 31,

2010


2009


2008(In thousands)

Average

Balance


Average

Rate Paid


Average

Balance


Average

Rate Paid


Average

Balance


Average

Rate PaidNoninterest bearing demand

$
210,367





$
226,648





$
214,372Interest bearing demand


258,674



.18
%


247,235



.29
%


256,129



.70
%Savings


272,080



.61



256,063



.77



261,692



1.34Time


807,730



2.51



902,066



3.38



793,561



4.25Total Interest Bearing


1,338,484



1.67



1,405,364



2.36



1,311,382



2.98Total

$
1,548,851



1.44
%

$
1,632,012



2.03
%

$
1,525,754



2.56
%





Maturities of time deposits of $100,000 or more outstanding at December 31, 2010 are summarized as follows.


(In thousands)

Amount3 months or less

$
42,396Over 3 through 6 months


37,200Over 6 through 12 months


65,075Over 12 months


96,797Total

$
241,468





Short-term Borrowings


Short-term borrowings consist primarily of federal funds purchased and securities sold under agreements to repurchase with year-end balances of $47.0 million, $46.9 million, and $73.2 million for 2010, 2009, and 2008, respectively. Such borrowings are generally on an overnight basis. Other short-term borrowings consist of FHLB borrowings totaling $0, $0, and $3.5 million at year-end 2010, 2009, and 2008, respectively, and demand notes issued to the U.S. Treasury under the treasury tax and loan note option account totaling $420 thousand, $274 thousand, and $787 thousand for 2010, 2009, and 2008 respectively. A summary of short-term borrowings is as follows:


(In thousands)

2010


2009


2008Amount outstanding at year-end

$
47,409


$
47,215


$
77,474Maximum outstanding at any month-end


76,848



105,844



125,096Average outstanding


46,483



62,946



81,180Weighted average rate at year-end


.56
%


.79
%


.74
%Weighted average rate during the year


.70



.72



2.20





Long-term Borrowings


The Company’s long-term borrowings consist mainly of securities sold under agreements to repurchase, FHLB advances, and subordinated notes payable to unconsolidated trusts. Long-term securities sold under agreements to repurchase represent obligations related to the Company’s 2007 balance sheet leverage transaction. In this transaction, the Company borrowed approximately $200 million through multiple fixed rate repurchase agreements and used the proceeds to purchase a like amount of fixed rate GNMA bonds. At December 31, 2010, the amount outstanding under long-term repurchase agreements was $150 million with a weighted average interest rate of 3.96%. Remaining maturities are $50.0 million which is due in November 2012 and the remaining $100 million is due in November 2017. At year-end 2010, $100 million of the borrowings are putable quarterly and the remaining $50.0 million is putable quarterly beginning in the fourth quarter of 2012.





FHLB advances to the Company’s subsidiary banks are secured by restricted holdings of FHLB stock that banks are required to own as well as certain mortgage loans as required by the FHLB. Such advances are made pursuant to several different credit programs which have their own interest rates and range of maturities. Interest rates on FHLB advances are generally fixed and range between 2.60% and 6.90%, with a weighted average rate of 4.01%.  Remaining maturities of FHLB advances extend up to 10 years, with a weighted average remaining term of 3.6 years at year-end 2010. Long-term fixed rate advances from the FHLB totaling $10.0 million are convertible to a floating interest rate. These advances may convert to a floating interest rate, indexed to the three-month LIBOR, only if LIBOR equals or exceeds 7%. At year-end 2010, the three-month LIBOR was .30%. FHLB advances are generally used to increase the Company’s lending activities and to aid the efforts of asset and liability management by utilizing various repayment options offered by the FHLB. Long-term advances from the FHLB totaled $53.1 million at December 31, 2010, a decrease of $14.5 million or 21.4% compared to $67.6 million at December 31, 2009.





The Company has previously completed three private offerings of trust preferred securities through three separate Delaware statutory trusts (the “Trusts”) sponsored by the Company in the aggregate amount of $47.5 million. The combined $25.0 million proceeds from the first




63








The Trusts used the proceeds from the sale of preferred securities, plus capital of $1.5 million contributed by the Company to establish the trusts, to purchase the Company’s subordinated notes in amounts and bearing terms that parallel the amounts and terms of the respective preferred securities. The subordinated notes of Trusts I and II mature in 2035 and bear a floating interest rate at current three-month LIBOR plus 150 basis points on a $10.3 million portion of the total and at current three-month LIBOR plus 165 basis points on a $15.5 million portion. The subordinated notes of Trust III in the amount of $23.2 million mature in 2037 and bear a fixed interest rate through 2012 of 6.60% and then convert to floating thereafter at three-month LIBOR plus 132 basis points. Interest on each of the notes is payable quarterly.





The subordinated notes of Trusts I and II became redeemable in whole or in part, without penalty, at the Company’s option beginning on September 30, 2010. The subordinated notes of Trust III are redeemable in whole or in part, without penalty, at the Company’s option on or after November 1, 2012. The subordinated notes are junior in right of payment of all present and future senior indebtedness of the Company. At December 31, 2010, the aggregate balance of the subordinated notes payable to the Trusts was $49.0 million. The weighted average interest rate in effect as of the last determination date in 2010 was 4.11%, unchanged compared to a year earlier.





Contractual Obligations


The Company’s contractual obligations to make future payments as of December 31, 2010 are as follows:


Payments Due by PeriodContractual Obligations (In thousands)

Total


Less Than

One Year


One to Three

Years


Three to Five

Years


More Than Five

YearsTime deposits

$
713,852


$
425,985


$
243,661


$
37,880


$
6,326Long-term FHLB debt


53,155



12,000



13,512



8,062



19,581Subordinated notes payable


48,970















48,970Long-term securities sold under agreements to repurchase


150,000







50,000







100,000Unfunded postretirement benefit obligations


5,171



398



835



958



2,980Operating leases


3,904



451



803



725



1,925Capital lease obligations


84



84Total

$
975,136


$
438,918


$
308,811


$
47,625


$
179,782





Long-term FHLB debt represents FHLB advances pursuant to several different credit programs. Long-term FHLB debt, subordinated notes payable, and securities sold under agreements to repurchase are more fully described under the caption “Long-Term Borrowings” above and in Note 9 of the Company’s 2010 audited consolidated financial statements. Payments for borrowings in the table above do not include interest. Postretirement benefit obligations are actuarially determined and estimated based on various assumptions with payouts projected over the next 10 years. Estimates can vary significantly each year due to changes in significant assumptions. Capital lease obligations represent amounts relating to the acquisition of data processing hardware and software used in the Company’s operations. Operating leases include standard business equipment used in the Company’s day-to-day business as well as the lease of certain branch sites. Operating lease terms generally range from one to five years, with the ability to extend certain branch site leases at the Company’s option. Payments related to leases are based on actual payments specified in the underlying contracts.





Guarantees


During 2007, the Parent Company entered into a guarantee agreement whereby it agreed to become unconditionally and irrevocably the guarantor of the obligations of its bank subsidiaries in connection with the $200 million balance sheet leverage transaction. The amount of borrowings outstanding guaranteed by the Parent Company at December 31, 2010 was $150 million, with various maturity dates ranging from two to seven years. The $150 million outstanding borrowings are secured by GNMA bonds held by the Parent Company’s subsidiary banks valued at 106% of the outstanding borrowings or $159 million. Should any of the subsidiary banks default on its borrowings under the agreement, the GNMA bonds securing the borrowings would be liquidated to satisfy amounts due. If the value of the GNMA bonds fall below the obligation under the contract, the Parent Company is obligated to cover any such shortfall in absence of the subsidiary banks ability to do so. The Parent Company believes its subsidiary banks are fully capable of fulfilling their obligations under the borrowing arrangement and that the Parent Company will not be required to make any payments under the guarantee agreement.





Effects of Inflation


The majority of the Company’s assets and liabilities are monetary in nature. Therefore, the Company differs greatly from most commercial and industrial companies that have significant investments in nonmonetary assets, such as fixed assets and inventories. However, inflation does have an important impact on the growth of assets in the banking industry and on the resulting need to increase equity capital at higher




64








Market Risk Management


Market risk is the risk of loss arising from adverse changes in market prices and rates. The Company’s market risk is comprised primarily of interest rate risk created by its core banking activities of extending loans and receiving deposits.  The Company’s success is largely dependent upon its ability to manage this risk. Interest rate risk is defined as the exposure of the Company’s net interest income to adverse movements in interest rates.  Although the Company manages other risks, such as credit and liquidity risk, management considers interest rate risk to be its most significant risk, which could potentially have the largest and a material effect on the Company’s financial condition and results of operations. A sudden and substantial change in interest rates may adversely impact the Company’s earnings to the extent that the interest rates earned on assets and paid on liabilities do not change at the same speed, to the same extent, or on the same basis.  Other events that could have an adverse impact on the Company’s performance include changes in general economic and financial conditions, general movements in market interest rates, and changes in consumer preferences. The Company’s primary purpose in managing interest rate risk is to effectively invest the Company’s capital and to manage and preserve the value created by its core banking business.





Management believes the most significant impact on financial and operating results is the Company’s ability to react to changes in interest rates.  Management seeks to maintain an essentially balanced position between interest sensitive assets and liabilities in order to protect against the effects of wide interest rate fluctuations.





The Company has a Corporate Asset and Liability Management Committee (“ALCO”). ALCO monitors the composition of the balance sheet to ensure comprehensive management of interest rate risk and liquidity. ALCO also provides guidance and support to each ALCO of the Company’s subsidiary banks and is responsible for monitoring risks on a company-wide basis. ALCO has established minimum standards in its asset and liability management policy that each subsidiary bank must adopt. However, the subsidiary banks are permitted to deviate from these standards so long as the deviation is no less stringent than that of the Corporate policy.





The Company uses a simulation model as a tool to monitor and evaluate interest rate risk exposure. The model is designed to measure the sensitivity of net interest income and net income to changing interest rates during the next twelve months. Forecasting net interest income and its sensitivity to changes in interest rates requires the Company to make assumptions about the volume and characteristics of many attributes, including assumptions relating to the replacement of maturing earning assets and liabilities. Other assumptions include, but are not limited to, projected prepayments, projected new volume, and the predicted relationship between changes in market interest rates and changes in customer account balances. These effects are combined with the Company’s estimate of the most likely rate environment to produce a forecast for the next twelve months. The forecasted results are then compared to the effect of a gradual 200 basis point increase and decrease in market interest rates on the Company’s net interest income and net income. Because assumptions are inherently uncertain, the model cannot precisely estimate net interest income or net income or the effect of interest rate changes on net interest income and net income. Actual results could differ significantly from simulated results.





At December 31, 2010, the model indicated that if rates were to gradually increase by 200 basis points over the next twelve months, then net interest income (TE) and net income would increase 3.2% and 8.6%, respectively, compared to forecasted results. The model indicated that if rates were to gradually decrease by 200 basis points over the next twelve months, then net interest income (TE) and net income would decrease 1.2% and 8.5%, respectively, compared to forecasted results.





In the current relatively low interest rate environment, it is not practical or possible to reduce certain deposit rates by the same magnitude as rates on earning assets. The average rate paid on many of the Company’s deposits is below 2%. This situation magnifies the model’s predicted results when modeling a decrease in interest rates, as earning assets with higher yields have more of an opportunity to reprice at lower rates than lower-rate deposits.





LIQUIDITY





Liquidity measures the ability to meet current and future cash flow needs as they become due. For financial institutions, liquidity reflects the ability to meet loan demand, to accommodate possible outflows in deposits, and to react and capitalize on interest rate market opportunities. A financial institution’s ability to meet its current financial obligations is dependent upon the structure of its balance sheet, its ability to liquidate assets, and its access to alternative sources of funds. The Company’s goal is to meet its near-term funding needs by maintaining a level of liquid funds through its asset/liability management. For the longer term, the liquidity position is managed by balancing the maturity structure of the balance sheet. This process allows for an orderly flow of funds over an extended period of time. The Company’s ALCOs, both at the bank subsidiary and consolidated level, meet regularly and monitor the composition of the balance sheet to ensure comprehensive management of interest rate risk and liquidity.




65





The Company's objective as it relates to liquidity is to ensure that its subsidiary banks have funds available to meet deposit withdrawals and credit demands without unduly penalizing profitability. In order to maintain a proper level of liquidity, the subsidiary banks have several sources of funds available on a daily basis that can be used for liquidity purposes. Those sources of funds include the subsidiary banks' core deposits, consisting of both business and nonbusiness deposits; cash flow generated by repayment of principal and interest on loans and investment securities; FHLB and other borrowings; and federal funds purchased and securities sold under agreements to repurchase. While maturities and scheduled amortization of loans and investment securities are generally a predictable source of funds, deposit outflows and mortgage prepayments are influenced significantly by general interest rates, economic conditions, and competition in our local markets.





As of December 31, 2010, the Company had $116 million of additional borrowing capacity under various FHLB, federal funds, and other borrowing agreements. However, there is no guarantee that these sources of funds will continue to be available to the Company, or that current borrowings can be refinanced upon maturity, although the Company is not aware of any events or uncertainties that are likely to cause a decrease in the Company’s liquidity from these sources.





The Company uses a liquidity ratio to help measure its ability to meet its cash flow needs. This ratio is monitored by ALCO at both the bank and consolidated level. The liquidity ratio is based on current and projected levels of sources and uses of funds. This measure is useful in analyzing cash needs and formulating strategies to achieve desired results. For example, a low liquidity ratio could indicate that the Company’s ability to fund loans might become more difficult. A high liquidity ratio could indicate that the Company may have a disproportionate amount of funds in low yielding assets, which is more likely to occur during periods of sluggish loan demand or economic difficulties. The Company’s liquidity position as measured by its liquidity ratio was relatively unchanged at year-end 2010 compared to year-end 2009 and is within ALCO guidelines and considered by management to be at an adequate level. The Company’s liquidity ratio remains relatively high as it continues to take a measured and cautious lending strategy and work through its high level of problem assets in an economic environment that remains challenging.





Liquidity at the Parent Company level is primarily affected by the receipt of dividends from its subsidiary banks (see Note 18 “Regulatory Matters” of the Company’s 2010 audited consolidated financial statements), cash balances maintained, short-term investments, investments in company-owned life insurance, and borrowings from nonaffiliated sources. Payment of dividends by the Company’s subsidiary banks is subject to certain regulatory restrictions as set forth in national and state banking laws and regulations. In addition, Farmers Bank, United Bank, and Citizens Northern each must obtain regulatory approval to declare or pay dividends to the Parent Company as a result of increased capital required in connection with recent regulatory exams. Capital ratios at each of the Company’s four subsidiary banks exceed regulatory established “well-capitalized” status at December 31, 2010 under the prompt corrective action regulatory framework; however, Farmers Bank, United Bank, and Citizens Northern are required to maintain capital ratios at higher levels as outlined in their regulatory agreements.





The Parent Company’s primary uses of cash include the payment of dividends to its common and preferred shareholders, injecting capital into subsidiaries, interest expense on borrowings, and paying for general operating expenses. Due to recent regulatory agreements, dividend payments on the Parent Company’s common and preferred stock and interest payments on its trust preferred borrowings must have regulatory approval before being paid. While regulatory agencies have so far granted approval to all of the Company’s requests to make interest payments on its trust preferred securities and dividends on its preferred stock, the Company did not (based on the assessment by Company management of both the Company’s capital position and the earnings of its subsidiaries) seek regulatory approval for the payment of common stock dividends.  Moreover, the Company will not pay any such dividend on its common stock in any subsequent quarter until the regulator’s assessment of the earnings of the Company’s subsidiaries, and the Company’s assessment of its capital position, both yield the conclusion that the payment of a Company common stock dividend is warranted. Reference is made to Note 18 “Regulatory Matters” of the Company’s 2010 audited consolidated financial statements, Item 1A “Risk Factors” of this Form 10-K, and the heading “Capital Resources” below for additional information on the Company’s restrictions and requirements related to the payment of interest and dividends.





The Parent Company had cash and cash equivalents of $16.2 million at December 31, 2010, an increase of $8.7 million or 115% from $7.6 million at year-end 2009. Significant cash receipts of the Parent Company during 2010 include $8.6 million proceeds from the liquidation of company-owned life insurance at the Parent Company, $5.2 million in dividends from First Citizens Bank, management fees from subsidiaries of $3.5 million, $1.5 million in dividends from FFKT Insurance, and $1.2 million return of capital from FCB Services. Significant cash payments by the Parent Company during 2010 include $3.4 million additional capital investment in bank subsidiaries, $2.2 million for the payment of common and preferred dividends, salaries, payroll taxes, and employee benefits of $2.4 million, interest expense on borrowed funds of $2.0 million, and $800 thousand additional capital injected into EKT Properties. The Parent Company may fund any additional external capital requirements of any of its banking subsidiaries from future public or private sales of securities at an appropriate time or from existing resources of the Company, although the Parent Company is currently under no directive by its regulators to raise any additional capital.





Liquid assets consist of cash, cash equivalents, and available for sale investment securities.  At December 31, 2010, consolidated liquid assets were $626 million, a decrease of $140 million or 18.3% from year-end 2009.  The decrease in liquid assets is attributed to a $104 million or 18.9% decrease in available for sale investment securities combined with a $36.3 million or 16.6% decrease in net cash and equivalents.




66








Net cash provided by operating activities was $28.1 million for 2010, an increase of $3.1 million or 12.4% compared to $25.0 million for 2009. Net cash provided by investing activities was $172 million for 2010 compared to net cash used of $8.8 million for 2009. The $181 million higher net cash inflow in the comparison is mainly due to $121 million related to investment securities transactions, $44.2 million related to loan activity, $9.6 million attributed to foreclosed real estate sales, and $8.6 million in connection with the conversion to cash of a portion of company-owned life insurance. For investment securities transactions, the Company had a net cash inflow of $104 million in 2010 resulting from maturities and sales activity that exceeded purchases. For 2009, the Company had net cash outflow related to investment securities of $16.9 million as purchases exceeded maturities and sales. Net cash repayments received on loans were $50.1 million for 2010 compared to $5.9 million for 2009 as funding new loans have decreased in the current year. The increase in cash received from foreclosed real estate activity is volume driven. The Company received $8.6 million proceeds during 2010 upon liquidation of part of its investment in company-owned life insurance at its cash surrender value to boost its cash available to inject into certain of its bank subsidiaries to strengthen their capital positions.





Net cash used in financing activities was $236 million in 2010 compared to net cash inflows of $11.3 million for 2009. For 2010, net deposits decreased $170 million, outstanding debt decreased $64.5 million, and dividends paid amounted to $2.2 million, all of which resulted in net cash outflows. For 2009, net cash flows from financing activities were increased by higher deposits of $39.3 million and proceeds from the issuance of preferred stock of $30.0 million, partially offset by net payments that reduced outstanding debt by $49.0 million and the payment of dividends totaling $9.2 million.





Information relating to off-balance sheet arrangements is disclosed in Note 15 of the Company’s 2010 audited consolidated financial statements. These transactions are entered into in the ordinary course of providing traditional banking services and are considered in managing the Company’s liquidity position. The Company does not expect these commitments to significantly affect the liquidity position in future periods. The Company has not entered into any contracts for financial derivative instruments such as futures, swaps, options, or similar instruments.





CAPITAL RESOURCES





Company





Shareholders’ equity was $150 million at December 31, 2010, an increase of $2.7 million or 1.8% compared to $147 million at December 31, 2009. Retained earnings increased $5.1 million during 2010 due to net income of $6.9 million partially offset by dividends and accretion on preferred stock of $1.9 million. There were no dividends declared on common stock in 2010. Other comprehensive income decreased $3.0 million mainly due to an overall net decline in the unrealized gain on available for sale investment securities. The decline in the overall net unrealized gain on available for sale investment securities was driven by the sale of securities in the current year and related gains that were recorded in noninterest income.





Although the Parent Company is currently under no directive by its regulators to raise any additional capital, the Company filed a registration statement on Form S-3 with the SEC that became effective on October 19, 2009. As part of that filing, equity securities of the Company of up to a maximum aggregate offering price of $70 million could be offered for sale in one or more public or private offerings at an appropriate time.  The Company continues to explore potential capital raising scenarios. However, no determination has been made as to if or when a capital raise will be completed. Net proceeds from a potential sale of securities under the registration statement could be used for any corporate purpose determined by the Company’s board of directors.





At December 31, 2010 the Company’s tangible capital ratio was 7.57% compared to 6.56% at year-end 2009. The tangible capital ratio is defined as tangible equity as a percentage of tangible assets. This ratio excludes amounts related to goodwill and other intangible assets. Tangible common equity to tangible assets, which further excludes outstanding preferred stock, was 6.09% at December 31, 2010 compared to 5.25% at year-end 2009.




67





Consistent with the objective of operating a sound financial organization, the Company’s goal is to maintain capital ratios well above the regulatory minimum requirements. The Company's capital ratios as of December 31, 2010 and the regulatory minimums are as follows.


Farmers Capital

Bank Corporation


Regulatory

MinimumTier 1 Risk-based Capital1


15.35
%


4.00
%Total Risk-based Capital1


16.61



8.00Tier 1 Leverage Capital2


9.39



4.00





1
Tier 1 Risk-based and Total Risk-based Capital ratios are computed by dividing a bank’s Tier 1 or Total Capital, as defined by regulation, by a risk-weighted sum of the bank’s assets, with the risk weighting determined by general standards established by regulation. The safest assets (e.g., government obligations) are assigned a weighting of 0% with riskier assets receiving higher ratings (e.g., ordinary commercial loans are assigned a weighting of 100%).


2
Tier 1 Leverage ratio is computed by dividing a bank’s Tier 1 Capital, as defined by regulation, by its total quarterly average assets.





The table below represents an analysis of dividend payout ratios and equity to asset ratios for the previous five years.


Years Ended December 31,

2010


2009


2008


2007


2006Percentage of common dividends declared to income from continuing operations


N/A



N/M



220.96
%


64.52
%


78.89
%Percentage of average shareholders’ equity to average total assets1


7.24
%


8.72
%


7.86



9.33



10.04





1Excludes assets of discontinued operations for 2006.


N/A-Not applicable.


N/M-Not meaningful.





In the summer of 2009 the Federal Reserve Bank of St. Louis (“FRB St. Louis”) conducted an examination of the Parent Company.  Primarily due to the regulatory actions and capital requirements at three of the Company’s subsidiary banks (as discussed below), the FRB St. Louis and Kentucky Department of Financial Institutions (“KDFI”) proposed the Company enter into a Memorandum of Understanding (“Memorandum”).  The Company’s board approved entry into the Memorandum at a regular board meeting during the fourth quarter of 2009.  Pursuant to the Memorandum, the Company agreed that it would develop an acceptable capital plan to ensure that the consolidated organization remains well-capitalized and each of its subsidiary banks meet the capital requirements imposed by their regulator as summarized below.





The Company also agreed to reduce its common stock dividend in the fourth quarter of 2009 from $.25 per share down to $.10 per share and not make interest payments on the Company’s trust preferred securities or dividends on its common or preferred stock without prior approval from FRB St. Louis and KDFI.  Representatives of the FRB St. Louis and KDFI have indicated that any such approval for the payment of dividends will be predicated on a demonstration of adequate, normalized earnings on the part of the Company’s subsidiaries sufficient to support quarterly payments on the Company’s trust preferred securities and quarterly dividends on the Company’s common and preferred stock.  While both regulatory agencies have granted approval of all subsequent quarterly Company requests to make interest payments on its trust preferred securities and dividends on its preferred stock, the Company has not (based on the assessment by Company management of both the Company’s capital position and the earnings of its subsidiaries) sought regulatory approval for the payment of common stock dividends since the fourth quarter of 2009.  Moreover, the Company will not pay any such dividends on its common stock in any subsequent quarter until the regulator’s assessment of the earnings of the Company’s subsidiaries, and the Company’s assessment of its capital position, both yield the conclusion that the payment of a Company common stock dividend is warranted.





Additionally, under the Memorandum, the Company agreed to:




·
utilize its financial and managerial resources to assist its subsidiary banks in addressing weaknesses identified at their most recent examinations and achieving and maintaining compliance with any regulatory supervisory actions respecting the subsidiary banks;


·
not pay any new salaries, bonuses, management fees or make any other payments to insiders without prior approval of the FRB St. Louis and the KDFI;


·
not incur additional debt or purchase or redeem any stock without the prior written approval of the FRB St. Louis and the KDFI;


·
submit to the FRB St. Louis and the KDFI an acceptable plan detailing the source and timing of funds for meeting the Company’s debt service requirements and other parent company expenses for 2010 and 2011; and


·
within thirty days of the end of each calendar quarter submit to the FRB St. Louis and the KDFI parent company financial statements along with a status report on compliance with the provisions of the Memorandum.




68


Subsidiary Banks





The Company’s subsidiary banks are subject to capital-based regulatory requirements which place banks in one of five categories based upon their capital levels and other supervisory criteria.  These five categories are: (1) well-capitalized, (2) adequately capitalized, (3) undercapitalized, (4) significantly undercapitalized, and (5) critically undercapitalized.  To be well-capitalized, a bank must have a Tier 1 Leverage Capital ratio of at least 5% and a Total Risk-based Capital ratio of at least 10%. As of December 31, 2010, the Company’s four subsidiary banks had the following capital ratios for regulatory purposes:




Tier 1 Leverage

Capital Ratio


Total Risk-based

Capital RatioFarmers Bank


8.55
%


16.86
%United Bank


8.24



14.18First Citizens Bank


8.46



13.50Citizens Northern


8.04



12.68




Three of the Company’s subsidiary banks, due to recent regulatory exams, are required to maintain capital ratios in excess of the well-capitalized level under the prompt corrective action framework. The capital levels required for these three banks and other requirements related to the applicable regulatory exam are discussed below.





Farmers Bank.  Farmers Bank was the subject of a regularly scheduled examination by the KDFI which was conducted in mid-September 2009.  As a result of this examination, the KDFI and FRB St. Louis entered into a Memorandum with Farmers Bank.  The Memorandum requires that Farmers Bank obtain written consent prior to declaring or paying the Parent Company a cash dividend and to achieve and maintain a Tier 1 Leverage ratio of 8.0% by June 30, 2010.  The Parent Company injected from its reserves $11 million in capital into Farmers Bank subsequent to the Memorandum.





At June 30, 2010, Farmers Bank had a Tier 1 Leverage ratio of 7.98% and a Total Risk-based Capital ratio of 15.78%. Subsequent to June 30, 2010, the Parent Company injected into Farmers Bank an additional $200 thousand in capital in order to raise its Tier 1 Leverage ratio to 8.0% to comply with the Memorandum. At December 31, 2010 Farmers Bank had a Tier 1 Leverage ratio of 8.55% and a Total Risk-based Capital ratio of 16.86%.





In addition to the above capital requirements and dividend restrictions, under the Memorandum Farmers Bank agreed to:





·
adopt, implement and adhere to a plan to reduce its risk position in each asset (loan) in excess of $750,000 which is delinquent or classified “Substandard” in its most recent examination, which plan must establish target dollar levels to which Farmers Bank will use best efforts to reduce delinquencies and classified assets at stated intervals and provide for monthly progress reports to the Farmers Bank board of directors;


·
not extend additional credit for any borrower already obligated to the Bank on any extension of credit that has either been (a) charged off (or classified “Loss” by regulators or in a subsequent review by the bank’s consultants or a regulatory body) as long as such credit remains uncollected, or (b) classified as “Substandard” or “Doubtful” and is uncollected, except in cases where the Farmers Bank board of directors approves such extension of credit as in the best interest of Farmers Bank;


·
submit to the FRB St. Louis and KDFI a written three-year strategic plan adopted by the Farmers Bank board of directors addressing mission statement, economic issues of the industries and markets served, strengths and weaknesses, strategies to improve earnings, staff training, financial goals, and identification of new lines of business and new types of lending;


·
address underwriting and credit administration concerns raised by regulators in their most recent examination;


·
address and monitor weaknesses regarding specific construction and development loans identified by regulators in their most recent examination;


·
formulate and implement a written profit plan consistent with Farmers Bank’s loan, investment and funds management policies and including realistic and comprehensive budgets and review processes, which profit plan is submitted to the FRB St. Louis and KDFI for review and comment; and


·
if, at the end of any quarter Farmers Bank’s Tier 1 Leverage ratio is less than 8.0%, within thirty days it must submit to the FRB St. Louis and KDFI a plan for implementation of the capital accounts of Farmers Bank or other measures to bring the ratio to the required 8.0% level.





69





Following is a summary of the level of substandard loans that meet the reporting requirements included in the Memorandum.





Substandard Loans


(Dollars in thousands)


Activity Since Exam DateAs of Exam Date


Increases


Decreases


December 31, 2010Number

of

Credits

Balance


Additional

Credit/New

Classifications


Number

of

Credits


Principal

Payments


Charge

Off’s


Transfers1


Balance


Number

of

Credits20

$
35,103


$
26,112



14


$
6,444


$
3,930


$
8,969


$
41,872



29





1 Of the total, $7.7 million represents repossession activity to other real estate owned and $1.2 million represents amounts that are no longer classified as substandard.





At December 31, 2010 Farmers Bank had 29 credit relationships with an aggregate outstanding balance of $41.9 million that meet the risk identification criteria established in the Memorandum. Farmers Bank’s targeted outstanding balance of assets meeting the risk identification criteria established in response to the Memorandum was $40.5 million for December 31, 2010. The outstanding balance at December 31, 2010 is in excess of the target amount by $1.3 million due mainly to newly classified credits. At September 30, 2010, the outstanding balance in excess of the target amount was $6.2 million. Local economic factors have negatively impacted housing markets which have contributed to the increase in nonperforming loans and assets.





The merger of Lawrenceburg Bank into Farmers Bank during the second quarter of 2010 also contributed to the increase in classified balances by $10.2 million. Included in this total are five credit relationships totaling $5.8 million that were classified substandard from the loan portfolio of Lawrenceburg Bank. In addition, there was $4.4 million in outstanding balances at Lawrenceburg Bank representing six credit relationships that also existed at Farmers Bank prior to the merger whereby the loans were participated between the two banks.





Lawrenceburg Bank. As a result of an examination conducted in March 2009, on May 15, 2009, Lawrenceburg Bank entered into a Memorandum with the FRB St. Louis and the KDFI. This Memorandum terminated effective upon Lawrenceburg Bank’s merger into Farmers Bank on May 8, 2010.





United Bank.  As a result of an examination conducted in late July and early August of 2009, the Federal Deposit Insurance Corporation (“FDIC”) proposed United Bank enter into a Cease and Desist Order (“Order”) primarily as a result of its level of nonperforming assets.  The Order requires United Bank to obtain written consent prior to declaring or paying the Parent Company a cash dividend and achieve and maintain a Tier 1 Leverage ratio of 8.0% by June 30, 2010 and a Total Risk-based Capital ratio of 12% immediately.   Subsequent to the Order, the Parent Company injected $10.5 million from its reserves into United Bank. In April 2010, the Parent Company injected an additional $1.9 million of capital into United Bank to bring its Tier 1 Leverage ratio up to the minimum 7.75% as of March 31, 2010 as required by the Order.  At June 30, 2010, United Bank had a Tier 1 Leverage ratio of 8.06% and a Total Risk-based Capital ratio of 14.12%. At December 31, 2010, United Bank had a Tier 1 Leverage ratio of 8.24% and a Total Risk-based Capital ratio of 14.18%.





Additionally, the Order requires United Bank to:





·
continue to retain qualified management, assessed on its ability to comply with the Order, operate United Bank in a safe and sound manner, comply with applicable laws, rules and regulations, and restore United Bank to a safe and sound condition;


·
not add directors or senior executive officers without prior approval of the FDIC and KDFI;


·
comply with certain disclosure guidelines in connection with selling any securities by United Bank to raise capital.  The Company and United Bank do not currently have plans to sell securities of United Bank to raise capital;


·
charge off any asset (loan) which was classified as a “Loss” by the FDIC and KDFI in their most recent examination;


·
not extend additional credit for any borrower obligated on any extension of credit that has been charged off (or classified as a “Loss” in the most recent examination), so long as the credit remains uncollected;


·
not extend additional credit for any borrower whose loan or other credit has been classified “Substandard” or “Doubtful” (or is listed as “Special Mention” by regulators in the most recent exam), and is uncollected, unless United Bank’s board of directors makes special determinations that extending such credit is in United Bank’s best interest;


·
adopt, implement and adhere to a plan to reduce its risk position in each borrower relationship in excess of $1,000,000 which is more than thirty days delinquent or classified as “Substandard” or “Doubtful” by regulators in the most recent examination.  Such plan is required to be submitted to the FDIC and KDFI and include a prohibition on extending credit to pay interest absent specific board determinations that such is in United Bank’s best interest, establish target levels to which  United Bank shall reduce delinquencies and classified assets within given time permits and provide for monthly reporting to United Bank’s board of directors on progress of the plan;




70




·
continue its practice of maintaining a written contingency funding plan which must be submitted to the FDIC and KDFI and on each Friday United Bank must submit to the FDIC and KDFI a liquidity analysis report;


·
not declare or pay dividends to the Parent Company without the prior written consent of the FDIC and KDFI;


·
prior to submission of its quarterly call reports, have its board of directors review its allowance for loan and lease losses (“ALLL”), provide an adequate ALLL and accurately report the ALLL;


·
continue its practice of adopting, implementing and adhering to a written profit plan and comprehensive budget for 2009 and 2010 and each year the Order is in effect, which must be submitted to the FDIC and KDFI for review and comment and include realistic and comprehensive budgets and review processes by both management and United Bank’s board of directors;


·
formulate, adopt and implement a plan to manage concentrations of credit that were identified by regulators in their most recent examination, which must provide for procedures for measurement and monitoring of concentrations of credit and a limit on concentrations commensurate with United Bank’s capital position, safe and sound banking practices and overall risk profile;


·
eliminate and correct all violations of laws, rules and regulations identified by the regulators in their most recent examination;


·
continue its practice of having procedures for managing its sensitivity to interest rate risk, which must implement recommendations of the regulators and be submitted to the FDIC and KDFI; and


·
the board of directors maintain a program to provide for monitoring United Bank’s compliance with the Order and on a quarterly basis United Bank’s directors are required to sign a progress report to be furnished to the FDIC and KDFI detailing actions taken by United Bank to secure compliance with the Order.





Following is a summary of the level of substandard loans that meet the reporting requirements included in the Order.








Substandard Loans
 (Dollars in thousands)


Activity Since Exam DateAs of Exam Date


Increases


Decreases


December 31, 2010Number

of

Credits

Balance


Additional

Credit/New

Classifications


Number

of

Credits


Principal

Payments


Charge

Off’s


Transfers1


Balance


Number

of

Credits15

$
42,870


$
51,509



18


$
16,585


$
7,122


$
13,468


$
57,204



27





1 Represents repossession activity to other real estate owned.





At December 31, 2010 United Bank had 27 credit relationships with an aggregate outstanding balance of $57.2 million that meet the risk identification criteria established in the Order. The aggregate amount of substandard loans outstanding at December 31, 2010 that meet the reporting criteria is below the target level established by United Bank resulting from the Order. Target levels are established based on projections of individual substandard loan amounts and will fluctuate depending on the actual amount of newly classified loans, principal reductions, or repossession activity.





Citizens Northern.  Citizens Northern was the subject of a regularly scheduled examination by the KDFI which was completed in late May 2010.  As a result of this examination, the KDFI and the FDIC on September 8, 2010 entered into a Memorandum with Citizens Northern.  The Memorandum requires that Citizens Northern obtain written consent prior to declaring or paying a dividend and to increase Tier 1 Leverage ratio to equal or exceed 7.5% prior to September 30, 2010 and to achieve and maintain Tier 1 Leverage ratio to equal or exceed 8.0% prior to December 31, 2010.  In December 2010, the Parent Company injected $250 thousand of capital into Citizens Northern to bring its Tier 1 Leverage ratio up to the minimum 8.0% as of year-end 2010 as required by the Order.  At December 31, 2010, Citizens Northern had a Tier 1 Leverage ratio of 8.04% and a Total Risk-based Capital ratio of 12.68%.





In addition to the above capital requirements and dividend restrictions, under the Memorandum Citizens Northern agreed to:





·
present to the FDIC and KDFI a plan for the augmentation of the capital accounts of the bank or other measures to bring the Tier 1 Leverage ratio to 8.0% if such ratio is less than 8.0% of the bank’s total assets as of March 31, June 30, September 30, or December 31 while the Memorandum is in effect;


·
formulate, adopt, and submit for review and comment a written plan of action to lessen its risk position in each asset classified  “Substandard” and “Doubtful” by regulators in the most recent examination, and which aggregated a relationship of $250,000 or more.  Such plan shall include


a) dollar levels to which it will strive to reduce each relationship within 6 and 12 months from the effective date of the Memorandum


b) provisions for the submission of monthly written progress reports to its board of directors for review and notation in the board of directors’ minutes;


·
not extend or renew any additional or existing credit to, or for the benefit of, any borrower who is already obligated in any manner to Citizens Northern on any extension of credit (including any portion thereof) that


71





a) has been charged off or classified as a “Loss” in the most recent examination or in any subsequent review by its consultants or by a regulatory body, so long as such credit remains uncollected


b) has been classified “Substandard” or “Doubtful” in the most recent examination, on the bank’s internal watch list, or in any subsequent review by its consultants, and is uncollected, unless its board of directors or loan committee has adopted, prior to such extension of credit, a detailed written statement giving the reasons why such extension of credit is in the best interest of the bank. A copy of the statement, including a thorough financial analysis gauging the borrowers financial condition and overall ability to service the existing and new debt, shall be placed in the appropriate loan file and shall be incorporated in the minutes of the applicable loan committee;


·
eliminate from its books, by collection, charge-off or other proper entries, all assets or potions of assets classified “Loss” by the FDIC and KDFI in their most recent examination that have not been previously charged off or collected;


·
take all steps necessary to correct all contraventions of statements of policy and all the violations scheduled on the Violations of Laws and Regulations pages in the most recent examination and adopt procedures to assure future compliance with all applicable statements of policies, laws, rules and regulations;


·
adopt, implement, and adhere to a written profit plan and a realistic, comprehensive budget for all categories of income and expense for calendar years 2010 through 2011. The plan and budgets shall contain formal goals and strategies, and a description of the operating assumptions that form the basis for major projected income and expense components. A copy of the plan and budgets shall be submitted to the FDIC and KDFI upon completion. The written profit plan shall address, at a minimum: income forecasts, national and local economic conditions forecasts, funding strategies, the bank’s asset structure, specific growth objectives, operating costs, and the likely effect of competition from other financial institutions in the bank’s market area. Within 30 days from the end of each calendar quarter following the completion of the profit plan(s) and budget(s), the bank’s board of directors shall evaluate the bank’s actual performance in relation to the plan and budget, record the results of the evaluation, and note any actions taken by the bank in the minutes of the board of directors’ meeting at which such evaluation is undertaken;


·
within 30 days following each calendar quarter after the date of the Memorandum, progress reports covering each of the provisions of the Memorandum shall be submitted to the FDIC and KDFI, until notification that the reports need no longer be submitted. The bank’s board of directors shall review all reports prior to submission and note their considerations in the minutes.





Following is a summary of the level of substandard loans that meet the reporting requirements included in the Memorandum.








Substandard Loans(Dollars in thousands)


Activity Since Exam DateAs of Exam Date


Increases


Decreases


December 31, 2010Number

of

Credits

Balance


Additional

Credit/New

Classifications


Number

of

Credits


Principal

Payments


Charge

Off’s


Transfers1


Balance


Number

of

Credits8

$
11,857


$
3,843



3


$
763


$
751


$
200


$
13,986



10




1 Represents repossession activity to other real estate owned.





At December 31, 2010 Citizens Northern had 10 credit relationships with an aggregate outstanding balance of $14.0 million that meet the risk identification criteria established in the Memorandum. There was no related target level established at year-end 2010.





At the Parent Company and at each of its bank subsidiaries, the Company believes it is adequately addressing all issues of the regulatory agreements to which it is subject. However, only the respective regulatory agencies can determine if compliance with the applicable regulatory agreements have been met. The Company and its subsidiary banks are in compliance with the requirements identified in the regulatory agreements as of December 31, 2010, with the exception that the level of substandard loans at Farmers Bank exceed the target amount by $1.3 million. Regulators continue to monitor the Company’s progress and compliance with the agreements through periodic on-site examinations, regular communications, and quarterly data analysis. The results of these examinations and communications show satisfactory progress toward meeting the requirements included in the regulatory agreements.





The Parent Company maintains cash available to fund a certain amount of additional injections of capital to its bank subsidiaries if required by its regulators. If needed, further amounts in excess of available cash may be funded by future public or private sales of securities, although the Parent Company is currently under no directive by its regulators to raise any additional capital.





Share Buy Back Program


At various times, the Company’s Board of Directors has authorized the purchase of shares of the Company’s outstanding common stock.  No stated expiration dates have been established under any of the previous authorizations. There are 84,971 shares that may still be purchased under the various authorizations. The Company’s participation in the Treasury’s CPP in early 2009 restricts the Company’s ability to purchase its outstanding common stock. Until January 9, 2012 the Company generally must have the Treasury’s approval before it can purchase its outstanding common stock, unless all of the Series A preferred stock issued under the CPP has been redeemed by the Company or transferred




72
 
  “Capital Resources”


Shareholder Information


As of February 22, 2011, the Company had 3,038 shareholders of record.





Common Stock Price


Farmers Capital Bank Corporation’s common stock is traded on the NASDAQ Stock Market LLC exchange in the Global Select Market tier, with sales prices reported under the symbol: FFKT. The table below lists the common stock prices and dividends declared for 2010 and 2009.





Common Stock Price


High


Low


Dividends

Declared12010Fourth Quarter

$
5.10


$
4.50Third Quarter


6.54



4.50Second Quarter


9.38



4.90First Quarter


10.52



6.592009Fourth Quarter

$
18.04


$
9.08


$
.10Third Quarter


26.90



17.10



.25Second Quarter


27.11



14.62



.25First Quarter


25.99



11.10



.25




1There were no dividends declared on the Company’s common stock during 2010.





The closing price per share of common stock on December 31, 2010, the last trading day of the Company’s fiscal year, was $4.88. Dividends declared per common share were $0 and $.85 for 2010 and 2009, respectively.





Recently Issued Accounting Standards


Please refer to the caption “Recently Issued But Not Yet Effective Accounting Standards” in Note 1 of the Company’s 2010 audited consolidated financial statements.





2009 Compared to 2008


A one-time, non-cash, $46.5 million after tax goodwill impairment charge led to a net loss for 2009 of $44.7 million or $6.32 per common share compared to net income of $4.4 million or $.60 per common share for 2008. On a pretax basis, the goodwill impairment charge was $52.4 million and recorded during the fourth quarter of 2009 and represents the entire amount of goodwill previously reported. The goodwill impairment charge had a negative impact of $6.31 per common share. The goodwill impairment charge was primarily the result of a prolonged decline in the Company’s stock price, a situation similar to many of its peer banks and other financial institutions at that time.  Lower stock prices were mainly attributed to the continuing economic weaknesses and increased market concern surrounding the credit risk and capital positions of financial institutions that began in late 2007.





For 2009, net interest income decreased $4.9 million or 8.4% compared to 2008 due mainly to lower interest on earning assets, primarily loans. Interest income on loans were negatively impacted by a higher level of nonaccrual loans and loans that repriced downward in an overall lower interest rate environment. Net interest margin was 2.85% for 2009, a decrease of 40 basis points from 3.25% in 2008. Net interest spread decreased 37 basis points to 2.61% for 2009 compared to 2.98% for 2008 and was driven mainly by the a 79 basis point decrease in the average rate earned from the loan portfolio.





The provision for loan losses increased $15.4 million in 2009 to $20.8 million compared to $5.3 million for 2008. The increase in the provision for loan losses was due to a higher level of nonperforming loans, primarily nonaccrual and restructured loans which trended upward as the overall economic environment and certain customers’ ability to repay their loans deteriorated. The allowance for loan losses at year-end 2009 was $23.4 million or 1.84% of loans net of unearned income. At year-end 2008, the allowance for loan losses was $16.8 million or 1.28% of loans net of unearned income.





Significant weaknesses in the general economy, particularly a softer housing market combined with significant credit tightening throughout the financial services industry began in 2007. Overall economic conditions, including widespread illiquidity and extreme volatility in financial markets, higher unemployment rates, and other unprecedented market conditions, continued to worsen in 2008 and into 2009 before beginning to stabilize toward the end of 2009. Unemployment remained high throughout 2009. These economic conditions resulted in significant stress primarily in the Company’s residential real estate development and commercial real estate sectors of its lending portfolio. As such,


73


the Company increased its allowance amounts for real estate development and commercial real estate lending in consideration of these current factors, even though historic net charge-offs had been relatively low.





Noninterest income for 2009 was $28.2 million, an increase of $18.4 million or 187% compared to $9.8 million for 2008. The increase in noninterest income was due mainly to the impact of an other-than-temporary impairment charge recorded in 2008 related to the Company’s investment in preferred stocks of the Federal Home Loan Mortgage Company and the Federal National Mortgage Association. This non-cash impairment charge reduced noninterest income during 2008 by $14.0 million. The increase in noninterest income between 2009 and 2009 was also positively impacted by an increase in net investment securities gains of $3.7 million.





Noninterest expenses were $55.0 million higher in 2009 compared to 2008. The increase in noninterest expenses is mainly due to the $52.4 million goodwill impairment charge mentioned above combined with an increase in deposit insurance expense of $2.7 million. The higher deposit insurance expense is due in part to the special assessment imposed by the FDIC during 2009 as part of its plan to replenish the Deposit Insurance Fund. The Company was able to offset a portion of its deposit insurance expense in 2008 with a one-time assessment credit it received during 2006. There were no credits remaining after 2008.





Item7A.  Quantitative and Qualitative Disclosures About Market Risk





The information required by this item is incorporated by reference to Part II, Item 7 under the caption “Market Risk Management” on page 65 of this Form 10-K.





74




Item8. Financial Statements and Supplementary Data





MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL REPORTING





The management of Farmers Capital Bank Corporation has the responsibility for preparing the accompanying consolidated financial statements and for their integrity and objectivity. The statements were prepared in accordance with accounting principles generally accepted in the United States of America. The consolidated financial statements include amounts that are based on management’s best estimates and judgments. Management also prepared other information in the annual report and is responsible for its accuracy and consistency with the financial statements.





The Company’s 2010 consolidated financial statements have been audited by Crowe Horwath LLP independent accountants. Management has made available to Crowe Horwath LLP all financial records and related data, as well as the minutes of Boards of Directors’ meetings.  Management believes that all representations made to Crowe Horwath LLP during the audit were valid and appropriate.











Lloyd C. Hillard, Jr.
C. Douglas CarpenterPresident and Chief Executive Officer
Executive Vice President, Secretary, and Chief Financial OfficerMarch 8, 2011




75




REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM













Board of Directors and Shareholders


Farmers Capital Bank Corporation


Frankfort, Kentucky





We have audited the accompanying consolidated balance sheets of Farmers Capital Bank Corporation as of December 31, 2010 and 2009 and the related consolidated statements of operations, changes in shareholders’ equity, comprehensive income (loss) and cash flows for each of the three years in the period ended December 31, 2010.  Farmers Capital Bank Corporation’s management is responsible for these financial statements.  Our responsibility is to express an opinion on these financial statements based on our audits.





We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting.  Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinion.





In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Farmers Capital Bank Corporation as of December 31, 2010 and 2009, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.








Crowe Horwath LLP


Louisville, Kentucky


March 8, 2011




76




ConsolidatedBalance Sheets
 December 31, (In thousands, except share data)

2010


2009AssetsCash and cash equivalents:Cash and due from banks

$
24,268


$
35,841Interest bearing deposits in other banks


139,902



175,926Federal funds sold and securities purchased under agreements to resell


17,886



6,569Total cash and cash equivalents


182,056



218,336Investment securities:Available for sale, amortized cost of $440,580 (2010) and $537,873 (2009)


444,182



547,873Held to maturity, fair value of $844 (2010) and $922 (2009)


930



975Total investment securities


445,112



548,848Loans, net of unearned income


1,192,840



1,271,942Allowance for loan losses


(28,784
)


(23,364
)Loans, net


1,164,056



1,248,578Premises and equipment, net


39,612



39,121Company-owned life insurance


28,791



36,626Other intangible assets, net


3,552



4,989Other real estate owned


30,545



31,232Other assets


41,969



43,832Total assets

$
1,935,693


$
2,171,562LiabilitiesDeposits:Noninterest bearing

$
206,887


$
214,518Interest bearing


1,256,685



1,418,915Total deposits


1,463,572



1,633,433Federal funds purchased and other short-term borrowings


47,409



47,215Securities sold under agreements to repurchase and other long-term borrowings


203,239



267,962Subordinated notes payable to unconsolidated trusts


48,970



48,970Dividends payable


188



925Other liabilities


22,419



25,830Total liabilities


1,785,797



2,024,335Commitments and contingencies(Notes 15 and 17)Shareholders’ EquityPreferred stock, no par value

1,000,000 shares authorized; 30,000 Series A shares issued and outstanding;

Liquidation preference of $30,000


28,719



28,348Common stock, par value $.125 per share; 14,608,000 shares authorized;

7,411,676 and 7,378,605 shares issued and outstanding at

December 31, 2010 and 2009, respectively


926



922Capital surplus


50,675



50,476Retained earnings


68,678



63,617Accumulated other comprehensive income


898



3,864Total shareholders’ equity


149,896



147,227Total liabilities and shareholders’ equity

$
1,935,693


$
2,171,562
 See accompanying notes to consolidated financial statements.
  77
 ConsolidatedStatements of Operations
 (In thousands, except per share data)Years Ended December 31,

2010


2009


2008Interest IncomeInterest and fees on loans

$
70,071


$
76,614


$
86,596Interest on investment securities:Taxable


16,565



20,424



22,894Nontaxable


2,835



3,570



3,231Interest on deposits in other banks


272



278



133Interest on federal funds sold and securities purchased under agreements to resell


8



24



1,066Total interest income


89,751



100,910



113,920Interest ExpenseInterest on deposits


22,373



33,197



39,045Interest on federal funds purchased and other short-term borrowings


324



453



1,785Interest on subordinated notes payable to unconsolidated trusts


2,035



2,178



2,865Interest on securities sold under agreements to purchase and other long-term borrowings


10,216



11,237



11,435Total interest expense


34,948



47,065



55,130Net interest income


54,803



53,845



58,790Provision for loan losses


17,233



20,768



5,321Net interest income after provision for loan losses


37,570



33,077



53,469Noninterest IncomeService charges and fees on deposits


9,171



9,347



9,847Allotment processing fees


5,573



5,403



4,791Other service charges, commissions, and fees


4,566



4,414



4,346Data processing income


1,328



1,317



1,087Trust income


1,688



1,763



2,032Investment securities gains (losses), net


8,889



3,488



(166
)Other-than-temporary impairment of investment securities










(13,962
)Gains on sale of mortgage loans, net


1,244



1,034



407Income from company-owned life insurance


1,300



1,282



1,235Other


351



121



193Total noninterest income


34,110



28,169



9,810Noninterest ExpenseSalaries and employee benefits


27,026



29,816



30,174Occupancy expenses, net


4,849



4,991



4,515Equipment expenses


2,647



3,075



3,187Data processing and communications expenses


5,448



5,568



5,423Bank franchise tax


2,482



2,265



2,158Correspondent bank fees


618



1,009



1,040Goodwill impairment






52,408Amortization of intangibles


1,437



1,952



2,602Deposit insurance expense


4,279



3,777



1,038Other real estate expenses, net


6,054



2,074



606Other


7,871



8,206



9,355Total noninterest expense


62,711



115,141



60,098Income (loss) before income taxes


8,969



(53,895
)


3,181Income tax expense (benefit)


2,037



(9,153
)


(1,214
)Net income (loss)


6,932



(44,742
)


4,395Dividends and accretion on preferred shares


(1,871
)


(1,802
)Net income (loss) available to common shareholders

$
5,061


$
(46,544
)

$
4,395Per Common ShareNet income (loss) – basic and diluted

$
.68


$
(6.32
)

$
.60Cash dividends declared


N/A



.85



1.32Weighted Average Shares OutstandingBasic and diluted


7,390



7,365



7,357
 See accompanying notes to consolidated financial statements.
  78
 ConsolidatedStatements of Comprehensive (Loss) Income
 (In thousands)Years Ended December 31,

2010


2009


2008Net income (loss)

$
6,932


$
(44,742
)

$
4,395Other comprehensive income (loss):Unrealized holding (loss) gain on available for sale securities arising during the period on securities held at end of period, net of tax of $377, $2,028, and $2,613, respectively


(701
)


3,767



4,853Reclassification adjustment for prior period unrealized (gain) loss previously reported in other comprehensive income recognized during current period, net of tax of $1,863, $1,187, and $85, respectively


(3,459
)


(2,204
)


(158
)Change in unfunded portion of postretirement benefit obligations, net of tax of $643, $234, and $613, respectively


1,194



(434
)


1,146Other comprehensive (loss) income


(2,966
)


1,129



5,841Comprehensive income (loss)

$
3,966


$
(43,613
)

$
10,236
 See accompanying notes to consolidated financial statements.
   79
 ConsolidatedStatements of Changes in Shareholders’ Equity
 (In thousands, except per share data)













Accumulated Other


TotalYears Ended

Preferred


Common Stock


Capital


Retained


Comprehensive


Shareholders’December 31, 2010, 2009, and 2008

Stock


Shares


Amount


Surplus


Earnings


(Loss) Income


EquityBalance at January 1, 2008





7,385


$
923


$
48,176


$
122,498


$
(3,106
)

$
168,491Net income

















4,395







4,395Other comprehensive income





















5,841



5,841Cash dividends declared, $1.32 per share

















(9,711
)






(9,711
)Purchase of common stock





(43
)


(5
)


(281
)


(763
)






(1,049
)Stock options exercised, including related tax benefits





1







30











30Shares issued pursuant to employee stock purchase plan





14



2



250











252Expense related to employee stock purchase plan and stock options













47











47Balance at December 31, 2008





7,357



920



48,222



116,419



2,735



168,296Issuance of  30,000 shares of Series A

preferred stock

$
28,008























28,008Issuance of common stock warrant














1,952











1,952Net loss


















(44,742
)






(44,742
)Other comprehensive income






















1,129



1,129Cash dividends declared-common, $.85 per share


















(6,258
)






(6,258
)Cash dividends declared-preferred, $48.73 per share


















(1,462
)






(1,462
)Preferred stock discount accretion


340















(340
)Shares issued pursuant to employee stock purchase plan






22



2



247











249Expense related to employee stock purchase plan














55











55Balance at December 31, 2009


28,348



7,379



922



50,476



63,617



3,864



147,227Net income


















6,932







6,932Other comprehensive loss






















(2,966
)


(2,966
)Cash dividends declared-preferred, $50.00 per share


















(1,500
)






(1,500
)Preferred stock discount accretion


371















(371
)Shares issued pursuant to employee stock purchase plan






33



4



153











157Expense related to employee stock purchase plan














46











46Balance at December 31, 2010

$
28,719



7,412


$
926


$
50,675


$
68,678


$
898


$
149,896
 See accompanying notes to consolidated financial statements.
 
 80
  ConsolidatedStatements of Cash Flows
  Years Ended December 31, (In thousands)

2010


2009


2008Cash Flows from Operating ActivitiesNet income (loss)

$
6,932


$
(44,742
)

$
4,395Adjustments to reconcile net income (loss) to net cash provided by operating activities:Depreciation and amortization


5,359



6,077



6,642Net premium amortization (discount accretion) of investment securities:Available for sale


2,232



955



(179
)Held to maturity






(1
)Provision for loan losses


17,233



20,768



5,321Goodwill impairment






52,408Deferred income tax benefit


(3,392
)


(9,905
)


(2,046
)Noncash stock option expense and employee stock purchase plan expense


46



55



47Mortgage loans originated for sale


(50,084
)


(45,806
)


(17,347
)Proceeds from sale of mortgage loans


50,761



46,994



16,185Gains on sale of mortgage loans, net


(1,244
)


(1,034
)


(407
)Loss on disposal of premises and equipment, net


(30
)


183



17Net loss (gain) on sale and write downs of repossessed real estate


4,878



1,074



(149
)Net (gain) loss on sale of available for sale investment securities


(8,889
)


(3,488
)


166Other-than-temporary impairment of investment securities










13,962Decrease in accrued interest receivable


2,123



2,787



1,169Income from company-owned life insurance


(1,044
)


(1,230
)


(1,225
)Death benefits in excess of cash surrender value on company-owned life insurance


(241
)Decrease (increase) in other assets


5,054



(1,027
)


(5,666
)Decrease in accrued interest payable


(1,874
)


(1,126
)


(634
)Increase in other liabilities


320



2,095



432Net cash provided by operating activities


28,140



25,037



20,683Cash Flows from Investing ActivitiesProceeds from maturities and calls of investment securities:Available for sale


315,480



239,192



219,724Held to maturity


45



840



2,030Proceeds from sale of available for sale investment securities


311,243



183,002



34,055Purchases of available for sale investment securities


(522,774
)


(439,777
)


(251,687
)Purchase of restricted stock investments


(368
)


(206
)


(480
)Loans originated for investment less (greater) than principal collected


50,085



5,920



(36,357
)Proceeds from liquidation of company-owned life insurance


8,567Proceeds from death benefits of company-owned life insurance


446Purchases of premises and equipment


(4,298
)


(2,165
)


(10,640
)Proceeds from sale of repossessed real estate


13,564



3,978



6,348Proceeds from disposals of equipment


60



422



2,357Net cash provided by (used in) investing activities


172,050



(8,794
)


(34,650
)Cash Flows from Financing ActivitiesNet (decrease) increase in deposits


(169,861
)


39,318



120,018Net increase (decrease) in federal funds purchased and other short-term borrowings


194



(30,259
)


(3,281
)Proceeds from securities sold under agreements to purchase and other long-term debt










27,000Repayments of securities sold under agreements to purchase and other long-term debt


(64,723
)


(18,729
)


(7,648
)Proceeds from issuance of preferred stock, net of issue costs






29,961Dividends paid, common and preferred stock


(2,237
)


(9,222
)


(9,720
)Purchase of common stock










(1,049
)Shares issued under Employee Stock Purchase Plan


157



249



252Stock options exercised and related tax benefits










30Net cash (used in) provided by financing activities


(236,470
)


11,318



125,602Net (decrease) increase in cash and cash equivalents


(36,280
)


27,561



111,635Cash and cash equivalents at beginning of year


218,336



190,775



79,140Cash and cash equivalents at end of year

$
182,056


$
218,336


$
190,775Supplemental DisclosuresCash paid during the year for:Interest

$
36,822


$
48,191


$
55,764Income taxes


2,989



2,450



6,600Transfers from loans to other real estate


17,771



20,332



14,622Transfers from premises to other real estate






1,506See accompanying notes to consolidated financial statements.
 
 81
 NOTESTO CONSOLIDATED FINANCIAL STATEMENTS
 
 1.
Summary of Significant Accounting Policies
 
 The accounting and reporting policies of Farmers Capital Bank Corporation and subsidiaries conform to accounting principles generally accepted in the United States of America and general practices applicable to the banking industry. Significant accounting policies are summarized below.
 
 Principles of Consolidation and Nature of Operations
 The consolidated financial statements include the accounts of Farmers Capital Bank Corporation (the “Company” or “Parent Company”), a bank holding company, and its bank and nonbank subsidiaries. Bank subsidiaries include Farmers Bank & Capital Trust Company (“Farmers Bank”) in Frankfort, KY and its significant wholly-owned subsidiaries Leasing One Corporation (“Leasing One”) and Farmers Capital Insurance Corporation (“Farmers Insurance”). Leasing One is a commercial leasing company in Frankfort, KY and Farmers Insurance is an insurance agency in Frankfort, KY. The Lawrenceburg Bank and Trust Company, which previously was a separate bank subsidiary of the Parent Company, was merged into Farmers Bank during the second quarter of 2010; First Citizens Bank in Elizabethtown, KY; United Bank & Trust Company (“United Bank”) in Versailles, KY which, during 2008, was the surviving company after the merger with two sister companies of Farmers Bank and Trust Company and Citizens Bank of Jessamine County; United Bank had one subsidiary at year-end 2010, EGT Properties, Inc. EGT Properties is involved in real estate management and liquidation for certain repossessed properties of United Bank; and Citizens Bank of Northern Kentucky, Inc. in Newport, KY (“Citizens Northern”); Citizens Northern had one subsidiary at year-end 2010, ENKY Properties, Inc. ENKY Properties is involved in real estate management and liquidation for certain repossessed properties of Citizens Northern.
 
 The Company has three active nonbank subsidiaries, FCB Services, Inc. (“FCB Services”), FFKT Insurance Services, Inc. (“FFKT Insurance”), and EKT Properties, Inc. (“EKT”). FCB Services is a data processing subsidiary located in Frankfort, KY that provides services to the Company’s banks as well as unaffiliated entities. FFKT Insurance is a captive property and casualty insurance company insuring primarily deductible exposures and uncovered liability related to properties of the Company. EKT was created in 2008 to manage and liquidate certain real estate properties repossessed by the Company. In addition, the Company has three subsidiaries organized as Delaware statutory trusts that are not consolidated into its financial statements. These trusts were formed for the purpose of issuing trust preferred securities. All significant intercompany transactions and balances are eliminated in consolidation.
 
 The Company provides financial services at its 36 locations in 23 communities throughout Central and Northern Kentucky to individual, business, agriculture, government, and educational customers. Its primary deposit products are checking, savings, and term certificate accounts.  Its primary lending products are residential mortgage, commercial lending, and installment loans. Substantially all loans and leases are secured by specific items of collateral including business assets, consumer assets, and commercial and residential real estate. Commercial loans and leases are expected to be repaid from cash flow from operations of businesses. Farmers Bank has served as the general depository for the Commonwealth of Kentucky for over 70 years and also provides investment and other services to the Commonwealth. Other services include, but are not limited to, cash management services, issuing letters of credit, safe deposit box rental, and providing funds transfer services.  Other financial instruments, which potentially represent concentrations of credit risk, include deposit accounts in other financial institutions and federal funds sold.
 
 Use of Estimates
 The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Estimates used in the preparation of the financial statements are based on various factors including the current interest rate environment and the general strength of the local economy.  Changes in the overall interest rate environment can significantly affect the Company’s net interest income and the value of its recorded assets and liabilities. Actual results could differ from those estimates used in the preparation of the financial statements. The allowance for loan losses, carrying value of other real estate owned, actuarial assumptions used to calculate postretirement benefits, and the fair values of financial instruments are estimates that are particularly subject to change.
 
 Reclassifications
 Certain amounts in the accompanying consolidated financial statements presented for prior years have been reclassified to conform to the 2010 presentation. These reclassifications do not affect net income or total shareholders’ equity as previously reported.
 
 Segment Information
 The Company provides a broad range of financial services to individuals, corporations, and others through its 36 banking locations throughout Central and Northern Kentucky. These services primarily include the activities of lending, receiving deposits, providing cash management services, safe deposit box rental, and trust activities. While the chief decision-makers monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis.   Operating segments are aggregated
 
 82
 into one as operating results for all segments are similar. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable segment.
 
 Cash Flows
 For purposes of reporting cash flows, cash and cash equivalents include the following: cash on hand, deposits from other financial institutions that have an initial maturity of less than 90 days when acquired by the Company, federal funds sold, and securities purchased under agreements to resell. Generally, federal funds sold and securities purchased under agreements to resell are purchased and sold for one-day periods.  Net cash flows are reported for loan, deposit, and short-term borrowing transactions.
 
 Investment Securities
 Investments in debt and equity securities are classified into three categories. Securities that management has the positive intent and ability to hold until maturity are classified as held to maturity. Securities that are bought and held specifically for the purpose of selling them in the near term are classified as trading securities. The Company had no securities classified as trading during 2010, 2009, or 2008. All other securities are classified as available for sale.  Securities are designated as available for sale if they might be sold before maturity. Securities classified as available for sale are carried at estimated fair value. Unrealized holding gains and losses for available for sale securities are reported net of deferred income taxes in other comprehensive income.  Investments classified as held to maturity are carried at amortized cost.
 
 Interest income includes amortization and accretion of purchase premiums or discounts. Premiums and discounts on securities are amortized using the interest method over the expected life of the securities without anticipating prepayments, except for mortgage backed securities where prepayments are anticipated. Realized gains and losses on the sales of securities are recorded on the trade date and computed on the basis of specific identification of the adjusted cost of each security and are included in noninterest income.
 
 The Company evaluates investment securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. A decline in the market value of investment securities below cost that is deemed other-than-temporary results in a charge to earnings and the establishment of a new cost basis for the security. Substantially all of the Company’s investment securities are debt securities. In estimating OTTI for debt securities, management considers each of the following: (1) the length of time and extent to which fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether market decline was affected by macroeconomic conditions, and (4) whether the Company has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery in fair value. The assessment of whether an OTTI charge exists involves a high degree of subjectivity and judgment and is based on the information available to the Company at a point in time.
 
 Investment securities classified as available for sale or held-to-maturity are generally evaluated for OTTI under Financial Accounting Standard Board (“FASB”) Accounting Standards CodificationTM (“ASC”) 320, “Investments-Debt and Equity Securities”. In determining OTTI under ASC 320 the Company considers many factors, including those enumerated above. When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether the Company intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss. If the Company intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If the Company does not intend to sell the security and it is not more likely than not that it will be required to sell the security before recovery of its amortized cost basis less any current-period loss, OTTI is separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors is recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment.
 
 Federal Home Loan Bank and Federal Reserve Board Stock
 Federal Home Loan Bank (“FHLB”) and Federal Reserve Board stock is carried at cost on the consolidated balance sheets under the caption “Other assets”. These stocks are classified as restricted securities and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income. The amounts outstanding at December 31, 2010 and 2009 were $9,515,000 and $9,148,000, respectively.
 
 Loans and Interest Income
 Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their unpaid principal amount outstanding adjusted for any charge-offs and any deferred fees or costs on originated loans. Interest income on loans is recognized using the interest method based on loan principal amounts outstanding during the period. Interest income also includes amortization and accretion of any premiums or discounts over the expected life of acquired loans at the time of purchase or business acquisition. Net fees and incremental direct costs associated with loan origination are deferred and amortized as yield adjustments over the contractual term of the loans.
 
 83
 New accounting rules effective at year-end 2010 require the Company to disaggregate certain disclosure information related to loans, the related allowance for loan losses, and credit quality measures by portfolio segment or by loan class. The Company segregates its loan portfolio segments based on similar risk characteristics and are as follows: real estate loans, commercial loans, and consumer loans. Portfolio segments are further disaggregated into classes for certain required disclosures as follows:
 
 Portfolio Segment
ClassReal estate loans
Real estate mortgage-construction and land development

Real estate mortgage-residential

Real estate mortgage-farmland and other commercial enterprisesCommercial loans
Commercial and industrial

Depository institutions

Agriculture production and other loans to farmers

States and political subdivisions

Leases

OtherConsumer loans
Secured

Unsecured
 
 New loan disclosures beginning at year-end 2010 include presenting certain disaggregated information based on recorded investment. The recorded investment in a loan includes its principal amount outstanding adjusted for certain items that include net deferred loan costs or fees, unamortized premiums or discounts, charge offs, and accrued interest. The Company had a total of $856,000 of net deferred loan costs at year-end 2010 included in the carrying amount of loans on the balance sheet, which represents .07% of average loans outstanding for 2010. The amount of net deferred loans costs are not material and are omitted from the computation of the recorded investment included in Note 4 that follows. Similarly, accrued interest receivable was $7,258,000 at year-end 2010 or .6% of average loans outstanding for 2010 and has also been omitted from certain information presented in Note 4.
 
 The Company’s has a loan policy in place that is amended and approved from time to time as needed to reflect current economic conditions and product offerings in its markets. The policy establishes written procedures concerning areas such as the lending authorities of loan officers, committee review and approval of certain credit requests, underwriting criteria, policy exceptions, appraisal requirements, and loan review. Credit is extended to borrowers based primarily on their ability to repay as demonstrated by income and cash flow analysis.
 
 Loans secured by real estate make up the largest segment of the Company’s loan portfolio. If a borrower fails to repay a loan secured by real estate, the Company may liquidate the collateral in order to satisfy the amount owed. Determining the value of real estate is a key component to the lending process for real estate backed loans. If the fair value of real estate (less estimated cost to sell) securing a collateral dependent loan declines below the outstanding loan amount, the Company will write down the carrying value of the loan and thereby incur a loss. The Company uses independent third party state-certified or licensed appraisers in accordance with its loan policy to mitigate risk when underwriting real estate loans. Cash flow analysis of the borrower, loan to value limits as adopted by loan policy, and other customary underwriting standards are also in place which are designed to maximize credit quality and mitigate risks associated with real estate lending.
 
 Commercial loans are made to businesses and are secured mainly by assets such as inventory, accounts receivable, machinery, fixtures and equipment, or other business assets. Commercial lending involves significant risk, as loan repayments are more dependent on the successful operation or management of the business and its cash flows. Consumer lending includes loans to individuals mainly for personal autos, boats, or a variety of other personal uses and may be secured or unsecured. Loan repayment associated with consumer loans is highly dependent upon the borrower’s continuing financial stability, which is heavily influenced by local unemployment rates. The Company mitigates its risk exposure to each of its loan segments by analyzing the borrower’s repayment capacity, imposing restrictions on the amount it will loan compared to estimated collateral values, limiting the payback periods, and following other customary underwriting practices as adopted in its loan policy.
 
 Generally, the accrual of interest on loans is discontinued when it is determined that the collection of interest or principal is doubtful, or when a default of interest or principal has existed for 90 days or more, unless such loan is well secured and in the process of collection. Past due status is based on the contractual terms of the loan.  All interest accrued but not received for loans placed on nonaccrual status is reversed against interest income. Cash payments received on nonaccrual loans generally are applied to principal, and interest income is only recorded once principal recovery is reasonably assured. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. The Company’s policy for placing a loan on nonaccrual status or subsequently returning a loan to accrual status does not differ based on its portfolio class or segment.
 
 84
 Commercial and real estate loans delinquent in excess of 120 days and consumer loans delinquent in excess of 180 days are charged off, unless the collateral securing the debt is of such value that any loss appears to be unlikely. In all cases, loans are charged off at an earlier date if classified as loss under its loan grading process or as a result of regulatory examination. The Company’s charge-off policy for impaired loans does not differ from the charge-off policy for loans outside the definition of impaired.
 
 Loans Held for Sale
 The Company’s operations include a limited amount of mortgage banking. Mortgage banking activities include the origination of fixed-rate residential mortgage loans for sale to various third-party investors. Mortgage loans originated and intended for sale in the secondary market, principally under programs with the Federal Home Loan Mortgage Corporation, the Federal National Mortgage Association, and other commercial lending institutions are carried at the lower of cost or estimated fair value determined in the aggregate and included in net loans on the balance sheet until sold. These loans are sold with the related servicing rights either retained or released by the Company depending on the economic conditions present at the time of origination. Mortgage loans held for sale included in net loans totaled $2,466,000 and $1,951,000 at December 31, 2010 and December 31, 2009, respectively. Mortgage banking revenues, including origination fees, servicing fees, net gains or losses on sales of mortgages, and other fee income were 1.20%, .97%, and .44% of the Company’s total revenue for the years ended December 31, 2010, 2009, and 2008.
 
 Provision and Allowance for Loan Losses
 The provision for loan losses represents charges made to earnings to maintain an allowance for loan losses at an adequate level based on credit losses specifically identified in the loan portfolio, as well as management’s best estimate of probable incurred loan losses in the remainder of the portfolio at the balance sheet date. The allowance for loan losses is a valuation allowance increased by the provision for loan losses and decreased by net charge-offs. Loan losses are charged against the allowance when management believes the uncollectibility of a loan is confirmed. Subsequent recoveries, if any, are credited to the allowance.
 
 Management estimates the allowance balance required using a risk-rated methodology. Many factors are considered when estimating the allowance. These include, but are not limited to, past loan loss experience, an assessment of the financial condition of individual borrowers, a determination of the value and adequacy of underlying collateral, the condition of the local economy, an analysis of the levels and trends of the loan portfolio, and a review of delinquent and classified loans. The allowance for loan losses 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 risk factors. 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. Actual loan losses could differ significantly from the amounts estimated by management.
 
 A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement.  Loans, for which the terms have been modified, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired.
 
 The Company’s risk-rated methodology includes segregating watch list and past due loans from the general portfolio and allocating specific amounts to these loans depending on their status. For example, watch list loans, which may be identified by the internal loan review risk-rating process or by regulatory examiner classification, are assigned a certain loss percentage while loans past due 30 days or more are assigned a different loss percentage. Each of these percentages considers past experience as well as current factors. The remainder of the general loan portfolio is segregated into portfolio segments having similar risk characteristics identified as follows:  real estate loans, commercial loans, and consumer loans. Each of these portfolio segments is assigned a loss percentage based on their respective rolling twelve quarter historical loss percentage. Additional allocations to the allowance may then be made for subjective factors, such as those mentioned above, as determined by senior managers who are knowledgeable about these matters. During 2007, the Company further identified signs of deterioration in certain real estate development loans that have remained present into 2010 and specific allowances related to these loans have been recorded.
 
 The Company accounts for impaired loans in accordance with ASC Topic 310, “Receivables”. ASC Topic 310 requires that impaired loans be measured at the present value of expected future cash flows, discounted at the loan’s effective interest rate, at the loan’s observable market price, or at the fair value of the collateral if the loan is collateral dependent. A loan is impaired when full payment under the contractual terms is not expected. Generally, impaired loans are also in nonaccrual status. In certain circumstances, however, the Company may continue to accrue interest on an impaired loan. Cash receipts on impaired loans are typically applied to the recorded investment in the loan, including any accrued interest receivable. Loans that are part of a large group of smaller-balance homogeneous loans, such as residential mortgage, consumer, and smaller-balance commercial loans, are collectively evaluated for impairment and, accordingly, they are not separately identified for impairment disclosures. Troubled debt restructurings are measured at the present value of estimated future cash flows using the loan’s effective interest rate at inception, or at the fair value of collateral.
 
 85
 Mortgage Servicing Rights
 Mortgage servicing rights are recognized in other assets on the Company’s consolidated balance sheet at their initial fair value on loans sold. Fair value is based on market price for comparable mortgage servicing contracts. Mortgage servicing rights are subsequently measured using the amortization method in which the mortgage servicing right is expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the rights, using groupings of the underlying loans as to interest rates. Any impairment of a grouping is reported as a valuation allowance. Capitalized mortgage servicing rights were $597,000 and $463,000 at December 31, 2010 and 2009. No impairment of the asset was determined to exist on either of these dates.
 
 Fair Value of Financial Instruments
 Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in Note 19.  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.
 
 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, that are 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.
 
 Goodwill and Other Intangible Assets
 Goodwill resulting from business combinations prior to January 1, 2009 represents the excess of the purchase price over the fair value of net assets of businesses acquired. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually and more frequently if events or circumstances indicate impairment could have taken place. Such events could include, among others, a significant adverse change in the business climate, an adverse action by a regulator, an unanticipated change in the competitive environment, or a decision to change the Company’s operations or disposal of a subsidiary. The Company performs its annual impairment test during the fourth quarter.  Prior to recording an impairment charge for the entire amount during the fourth quarter of 2009, goodwill was the only intangible asset with an indefinite life on the Company’s balance sheet. See Note 22 for further discussion of the Company’s 2009 goodwill impairment analysis.
 
 Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. Such intangible assets consist of core deposit and acquired customer relationship intangible assets arising from business acquisitions. They are initially measured at fair value and then are amortized on an accelerated method over their estimated useful lives, which range between seven and 10 years.
 
 Other Real Estate Owned
 Other real estate owned (“OREO”) and held for sale in the accompanying consolidated balance sheets includes properties acquired by the Company through actual loan foreclosures. OREO is carried at fair value less estimated costs to sell. Fair value of assets is generally based on third party appraisals of the property that includes comparable sales data. If the carrying amount exceeds fair value less estimated costs to sell, an impairment loss is recorded through expense. Costs after acquisition are expensed.
 
 Income Taxes
 Income tax expense is the total of current year income tax due or refundable and the change in deferred tax assets and liabilities, except for the deferred tax assets and liabilities related to business combinations or components of other comprehensive income.Deferred income tax assets and liabilities result from temporary differences between the tax basis of assets and liabilities and their reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in years in which those temporary differences are expected to be recovered or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through income tax expense. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.
 
 A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur.  The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination.  For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
 
 The Company files a consolidated federal income tax return with its subsidiaries. Federal income tax expense or benefit has been allocated to subsidiaries on a separate return basis.
 
 86
 Premises and Equipment
 Premises, equipment, and leasehold improvements are stated at cost less accumulated depreciation and amortization. Depreciation is computed primarily on the straight-line method over the estimated useful lives generally ranging from two to seven years for furniture and equipment and generally ten to 40 years for buildings and related components. Leasehold improvements are amortized over the shorter of the estimated useful lives or terms of the related leases on the straight-line method. Maintenance, repairs, and minor improvements are charged to operating expenses as incurred and major improvements are capitalized. The cost of assets sold or retired and the related accumulated depreciation are removed from the accounts and any resulting gain or loss is included in noninterest income. Land is carried at cost.
 
 Company-owned Life Insurance
 The Company has purchased life insurance policies on certain key employees with their knowledge and written consent. Company-owned life insurance is recorded at its cash surrender value, i.e. the amount that can be realized under the insurance contract, on the consolidated balance sheet. The related change in cash surrender value and proceeds received under the policies are reported on the consolidated statement of income under the caption “Income from company-owned life insurance”.
 
 Related Party Transactions
 In the ordinary course of business, the Company offers loan and deposit products to its directors, executive officers, and principal shareholders-including affiliated companies of which they are principal owners (“Related Parties”). These products are offered on substantially the same terms as those prevailing at the time for comparable transactions with unrelated parties, and these receivables and deposits are included in loans and deposits in the Company’s consolidated balance sheets. Additional information related to these transactions can be found in Note 3 and Note 7 to these audited consolidated financial statements.
 
 The Company makes payments to Related Parties in the normal course of business for various services, primarily related to legal fees. For example, certain directors of the Parent Company and its subsidiary banks are partners in law firms that act as counsel to the Company. The following table represents the amount and type of payments to Related Parties, other than director fees, for the periods indicated:
 
 (In thousands)

Years Ended December 31,

2010


2009


2008Legal fees

$
499


$
532


$
370Insurance commissions


5Premises rental










10Other


16



19



16Total

$
520


$
551


$
396
 
 Retirement Plans
 The Company maintains a 401(k) salary savings plan and records expense based on the amount of its matching contributions of employee deferrals.  The Company also has a nonqualified supplemental retirement plan for certain key employees that it acquired in connection with the Citizens Northern acquisition. Supplemental retirement plan expense allocates the benefits over years of service.
 
 Net Income (Loss) Per Common Share
 Basic net income (loss) per common share is determined by dividing net income (loss) available to common shareholders by the weighted average total number of common shares issued and outstanding.  Net income (loss) available to common shareholders represents net income (loss) adjusted for preferred stock dividends including dividends declared, accretion of discounts on preferred stock issuances, and cumulative dividends related to the current dividend period that have not been declared as of the end of the period.
 
 Diluted net income per common share is determined by dividing net income available to common shareholders by the total weighted average number of common shares issued and outstanding plus amounts representing the dilutive effect of stock options outstanding and outstanding warrants. The effects of stock options and outstanding warrants are excluded from the computation of diluted earnings per common share in periods in which the effect would be antidilutive. Dilutive potential common shares are calculated using the treasury stock method.
 
 87
 Net income (loss) per common share computations were as follows at December 31, 2010, 2009, and 2008:
 (In thousands, except per share data)

Years Ended December 31,

2010


2009


2008Net income (loss), basic and diluted

$
6,932


$
(44,742
)

$
4,395Preferred stock dividends and discount accretion


(1,871
)


(1,802
)Net income (loss) available to common shareholders, basic and diluted

$
5,061


$
(46,544
)

$
4,395Average common shares outstanding, basic and diluted


7,390



7,365



7,357Net income (loss) per common share, basic and diluted

$
.68


$
(6.32
)

$
.60
 
 Stock options for 24,049, 57,621, and 59,621 shares of common stock for 2010, 2009, and 2008, respectively, were not included in the determination of dilutive earnings per common share because they were antidilutive. There were 223,992 potential common shares associated with a warrant issued to the U.S. Treasury that were excluded from the computation of earnings per common share for 2010 and 2009 because they were antidilutive. There were no warrants outstanding prior to 2009.
 
 Comprehensive Income (Loss)
 Comprehensive income (loss) is defined as the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. For the Company this includes net income (loss), the after tax effect of changes in the net unrealized gains and losses on available for sale investment securities, and the changes in the funded status of postretirement benefit plans.
 
 Dividend Restrictions
 Banking regulations require maintaining certain capital levels and currently limit the dividends paid to the Company by its bank subsidiaries or by the Company to its shareholders.
 
 Restrictions on Cash
 Included in interest bearing deposits in other banks on the consolidated balance sheets are certain amounts that are held at the Federal Reserve Bank in accordance with reserve requirements specified by the Federal Reserve Board of Governors. The reserve requirement was $15,461,000 and $12,827,000 at December 31, 2010 and 2009, respectively.
 
 Equity
 Outstanding common shares purchased by the Company are retired. When common shares are purchased, the Company allocates a portion of the purchase price of the common shares that are retired to each of the following balance sheet line items: common stock, capital surplus, and retained earnings.
 
 Trust Assets
 Assets of the Company’s trust departments, other than cash on deposit at our subsidiaries, are not included in the accompanying financial statements because they are not assets of the Company.
 
 Transfers of Financial Assets
 Transfers of financial assets are accounted for as sales when control over the assets has been relinquished.  Control over transferred assets is deemed to be surrendered when the assets have been isolated from the Company, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
 
 Long-term Assets
 Premises and equipment, core deposit and other intangible assets, and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows.  If impaired, the assets are recorded at fair value.
 
 Stock-Based Compensation
 The Company recognizes compensation cost for its Employee Stock Purchase Plan (“ESPP”) and for stock options granted based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of ESPP and stock option awards. Compensation cost is recognized over the required service period, generally defined as the vesting period, on a straight-line basis.
 
 The Company’s ESPP was approved by its shareholders at the Company’s 2004 annual meeting. The purpose of the ESPP is to provide a means by which eligible employees may purchase, at a discount, shares of common stock of the Company through payroll withholding. The purchase price of the shares is equal to 85% of their fair market value on specified dates as defined in the plan. The ESPP was effective
 
 88
 beginning July 1, 2004. There were 33,071, 21,243, and 14,497 shares issued under the plan during 2010, 2009, and 2008, respectively. Compensation expense related to the ESPP included in the accompanying statements of income was $46,000, $55,000, and $47,000 in 2010, 2009, and 2008, respectively.
 
 Following are the weighted average assumptions used and estimated fair market value for the ESPP, which is considered a compensatory plan under ASC Topic 718, “Compensation-Stock Compensation”.
 ESPP2010


2009


2008Dividend yield


0
%


4.63
%


4.24
%Expected volatility


66.0



56.8



24.1Risk-free interest rate


.15



.14



1.85Expected life (in years)


.25



.25



.25Fair value

$
1.45


$
3.67


$
4.05
 
 Adoption of New Accounting Standards
 ASC Topic 860,“Transfers and Servicing”. Effective January 1, 2010, the Company adopted new accounting guidance under ASC Topic 860 that requires more information about transfers of financial assets, including securitization transactions, and where entities have continuing exposure to the risks related to transferred financial assets. The guidance eliminates the concept of a “qualifying special-purpose entity,” changes the requirements for derecognizing financial assets, and requires additional disclosures about continuing involvements with transferred financial assets including information about gains and losses resulting from transfers during the period. The adoption of this accounting guidance did not have a material impact on the Company’s consolidated financial position or results of operations.
 
 ASC Topic 810,“Consolidation”. Effective January 1, 2010, the Company adopted new accounting guidance under ASC Topic 810 that amends prior guidance to change how a reporting entity determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a reporting entity is required to consolidate another entity is based on, among other things, the other entity’s purpose and design and the reporting entity’s ability to direct the activities of the other entity that most significantly impact the other entity’s economic performance. The new guidance requires a number of new disclosures about an entity’s involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A reporting entity will also be required to disclose how its involvement with a variable interest entity affects the reporting entity’s financial statements. The adoption of this accounting guidance did not have a material impact on the Company’s consolidated financial position or results of operations.
 
 ASC Topic 820,“Fair Value Measurements and Disclosures”. The FASB issued accounting guidance under Accounting Standards Update (“ASU”) No. 2010-06 that requires new disclosures and clarifies existing disclosure requirements about fair value measurements as set forth in ASC Subtopic 820-10. The objective of the new guidance is to improve these disclosures and increase transparency in financial reporting. Specifically, the new guidance requires:
 
 ·
A reporting entity to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers; and
 
 ·
In the reconciliation for fair value measurements using significant unobservable inputs, a reporting entity should present separately information about purchases, sales, issuances, and settlements.
 
 In addition, the guidance clarifies the requirements of the following existing disclosures:
 
 ·
For purposes of reporting fair value measurement for each class of assets and liabilities, a reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities; and
 
 ·
A reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements.
 
 ASU 2010-06 is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. Early application is permitted. The portion that is currently effective did not have a material impact on the Company’s consolidated financial position or results of operations. The portion that is not yet effective is not expected to have a material impact on the Company’s consolidated financial position or results of operations.
 
 89
 ASC Topic 310,“Receivables: Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses”. The FASB issued accounting guidance under ASU No. 2010-20 that requires significant new disclosures about the allowance for credit losses and the credit quality of financing receivables. The objectives of the new guidance are intended to improve transparency regarding credit losses and the credit quality of loan and lease receivables. The new guidance requires the allowance for loan losses to be disclosed by portfolio segment, while credit quality information, impaired loans, and age analysis are to be presented by class. Disclosure of the nature and extent of troubled debt restructurings is also required. The disclosures are to be presented at the level of disaggregation that management uses when assessing and monitoring the portfolio’s risk and performance.
 
 The new disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010.  Additionally, the FASB in December 2010 issued an exposure draft “Receivables (Topic 310): Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20”.  This proposed guidance, which became effective in January 2011, delays the new disclosure requirements for troubled debt restructurings activity until interim and annual reporting periods ending after June 15, 2011. Refer to Note 3 “Loans” for further information about the Company’s disclosures required by this Topic. Disclosures related to troubled debt restructuring activity that are not yet effective are not expected to have a material impact on the Company’s consolidated financial position or results of operations.
 
 Recently Issued But Not Yet Effective Accounting Standards
 Please refer to the caption “Adoption of New Accounting Standards” immediately above for information about certain portions of newly adopted accounting standards that will be effective in 2011.
 
 2.
Investment Securities
 
 The following tables summarize the amortized cost and estimated fair values of the securities portfolio at December 31, 2010 and 2009 and the corresponding amounts of gross unrealized gains and losses.  The summary is divided into available for sale and held to maturity securities.
 Gross


GrossAmortized


Unrealized


Unrealized


EstimatedDecember 31, 2010 (In thousands)

Cost


Gains


Losses


Fair ValueAvailable For SaleObligations of U.S. government-sponsored entities

$
42,103


$
58


$
548


$
41,613Obligations of states and political subdivisions


75,004



923



1,128



74,799Mortgage-backed securities – residential


314,799



7,527



2,396



319,930U.S. Treasury securities


1,043



1







1,044Money market mutual funds


145











145Corporate debt securities


7,441







835



6,606Equity securities


45











45Total securities – available for sale

$
440,580


$
8,509


$
4,907


$
444,182Held To MaturityObligations of states and political subdivisions

$
930


$
0


$
86


$
844
 
 Gross


GrossAmortized


Unrealized


Unrealized


EstimatedDecember 31, 2009 (In thousands)

Cost


Gains


Losses


Fair ValueAvailable For SaleObligations of U.S. government-sponsored entities

$
90,889


$
162


$
299


$
90,752Obligations of states and political subdivisions


107,190



2,423



655



108,958Mortgage-backed securities – residential


315,546



10,446



473



325,519U.S. Treasury securities


2,997



5







3,002Money market mutual funds


910











910Corporate debt securities


20,341



195



1,804



18,732Total securities – available for sale

$
537,873


$
13,231


$
3,231


$
547,873Held To MaturityObligations of states and political subdivisions

$
975






$
53


$
922
 
 At year-end 2010 and 2009, the Company held no investment securities of any single issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of shareholders’ equity.
 
 The amortized cost and estimated fair value of the securities portfolio at December 31, 2010, by contractual maturity, are detailed below. The summary is divided into available for sale and held to maturity securities. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Equity securities in the available
 
 90
 for sale portfolio at December 31, 2010 consist of investments attributed to the Company’s captive insurance subsidiary. These securities have no stated maturity and are not included in the maturity schedule that follows.
 
 Mortgage-backed securities are stated separately due to the nature of payment and prepayment characteristics of these securities, as principal is not due at a single date.
 Available For Sale


Held To MaturityAmortized


Estimated


Amortized


EstimatedDecember 31, 2010 (In thousands)

Cost


Fair Value


Cost


Fair ValueDue in one year or less

$
7,634


$
7,684Due after one year through five years


48,507



48,646Due after five years through ten years


47,448



46,993Due after ten years


22,147



20,884


$
930


$
844Mortgage-backed securities – residential


314,799



319,930Total

$
440,535


$
444,137


$
930


$
844
 
 Gross realized gains and losses on the sale of available for sale investment securities were as follows for the year indicated.
 
 (In thousands)

2010


2009


2008Gross realized gains

$
9,166


$
3,560


$
713Gross realized losses


277



72



879Net realized gain (loss)

$
8,889


$
3,488


$
(166
)Income tax provision (benefit) related to net realized gains (losses)

$
3,111


$
1,221


$
(58
)Proceeds from sales and calls of available for sale investment securities

$
548,551


$
314,623


$
94,039
 
 Gross losses for 2008 include $766,000 related to the sale of preferred stock investments in Federal National Mortgage Association and Federal Home Loan Mortgage Corporation.
 
 Investment securities with a carrying value of $301,385,000 and $389,001,000 at December 31, 2010 and 2009 were pledged to secure public and trust deposits, repurchase agreements, and for other purposes.
 
 91
 Investment securities with unrealized losses at year-end 2010 and 2009 not recognized in income are presented in the tables below. The tables segregate investment securities that have been in a continuous unrealized loss position for less than twelve months from those that have been in a continuous unrealized loss position for twelve months or more. The table also includes the fair value of the related securities.
 Less than 12 Months


12 Months or More


TotalDecember 31, 2010 (In thousands)

Fair Value


Unrealized

Losses


Fair Value


Unrealized

Losses


Fair Value


Unrealized

LossesObligations of U.S. government-sponsored entities

$
32,000


$
548








$
32,000


$
548Obligations of states and political subdivisions


22,517



1,028


$
5,733


$
186



28,250



1,214Mortgage-backed securities – residential


165,426



2,396











165,426



2,396Corporate debt securities










4,989



835



4,989



835Total

$
219,943


$
3,972


$
10,722


$
1,021


$
230,665


$
4,993
 
 
 Less than 12 Months


12 Months or More


TotalDecember 31, 2009 (In thousands)

Fair Value


Unrealized

Losses


Fair Value


Unrealized

Losses


Fair Value


Unrealized

LossesObligations of U.S. government-sponsored entities

$
39,445


$
299








$
39,445


$
299Obligations of states and political subdivisions


22,795



552


$
3,605


$
156



26,400



708Mortgage-backed securities – residential


41,120



473











41,120



473Corporate debt securities










11,710



1,804



11,710



1,804Total

$
103,360


$
1,324


$
15,315


$
1,960


$
118,675


$
3,284
  Unrealized losses included in the tables above have not been recognized in income since they have been identified as temporary. The Company evaluates investment securities for other-than-temporary impairment at least quarterly, and more frequently when economic or market conditions warrant. Many factors are considered, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was effected by macroeconomic conditions, and (4) whether the Company has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an OTTI charge exists involves a high degree of subjectivity and judgment and is based on the information available to the Company at a point in time.
 
 At December 31, 2010, the Company’s investment securities portfolio had gross unrealized losses of $5.0 million. Of the total gross unrealized losses, $1.0 million is related to investments that have been in a continuous loss position for 12 months or more. Unrealized losses on corporate debt securities account for $835 thousand of the total unrealized loss on investment securities in a continuous loss position of 12 months or more. This represents an improvement of $969 thousand or 53.7% from December 31, 2009. During the second quarter of 2010, the Company sold $12.1 million amortized cost amount of its corporate debt securities for a net loss of $168 thousand and another $1.0 million matured. These debt securities, although still rated as investment grade, were downgraded during 2009 and sold in the second quarter of 2010 after a careful analysis of their short and long-term prospects determined they no longer suited the Company’s investment preferences.
 
 The remaining corporate debt securities in the Company’s investment securities portfolio at December 31, 2010 consist primarily of single-issuer trust preferred capital securities issued by a national and global financial services firm. Each of these securities is currently performing and the issuer of these securities continues to be rated as investment grade by major rating agencies, although downgrades occurred within this group of holdings during 2009. The unrealized loss on corporate debt securities is primarily attributed to the general decline in financial markets and illiquidity events that began in 2008 and is not due to adverse changes in the expected cash flows of the individual securities. Overall market declines, particularly of banking and financial institutions, are a result of significant stress throughout the regional and national economy that began during 2008 that, while beginning to improve, has not fully stabilized.
 
 The Company attributes the unrealized losses in other sectors of its investment securities portfolio to changes in market interest rates. In general, market rates for these securities exceed the yield available at the time many of the securities in the portfolio were purchased. The Company does not expect to incur a loss on these securities unless they are sold prior to maturity. The Company’s current intent is to hold these securities until recovery.
 
 Investment securities with unrealized losses at December 31, 2010 are performing according to their contractual terms. The Company does not have the intent to sell these securities and likely will not be required to sell these securities before their anticipated recovery. The Company does not consider any of the securities to be impaired due to reasons of credit quality or other factors.
 
 92
 3.
Loans
 
 Major classifications of loans are summarized in the following tables. During the transition year, the amounts for 2010 and 2009 are presented in separate tables as a result of the expanded disclosures categories required by ASU No. 2010-20.
 December 31, (In thousands)

2010Real Estate:Real estate – construction and land development

$
154,208Real estate mortgage – residential


469,273Real estate mortgage – farmland and other commercial enterprises


416,904Commercial:Commercial and industrial


57,029States and political subdivisions


26,302Lease financing


16,187Other


25,628Consumer:Secured


22,607Unsecured


5,925Total loans


1,194,063Less unearned income


(1,223
)Total loans, net of unearned income

$
1,192,840
  December 31, (In thousands)

2009Commercial, financial, and agricultural

$
146,530Real estate – construction


211,744Real estate mortgage – residential


466,018Real estate mortgage – farmland and other commercial enterprises


386,626Installment loans


36,727Lease financing


26,765Total loans


1,274,410Less unearned income


(2,468
)Total loans, net of unearned income

$
1,271,942
 
 Loans to directors, executive officers, and principal shareholders (including loans to affiliated companies of which they are principal owners) and loans to members of the immediate family of such persons were $23,188,000 and $24,767,000 at December 31, 2010 and 2009, respectively. Such loans were made in the normal course of business on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other customers and did not involve more than the normal risk of collectability. An analysis of the activity with respect to these loans is presented in the table below.
 (In thousands)

AmountBalance, December 31, 2009

$
24,767New loans


17,200Repayments


(11,406
)Loans no longer meeting disclosure requirements, new loans meeting disclosure requirements, and other adjustments, net


(7,373
)Balance, December 31, 2010

$
23,188
  4.
Allowance for Loan Losses
 
 Activity in the allowance for loan losses was as follows:
 Years Ended December 31, (In thousands)

2010


2009


2008Balance, beginning of year

$
23,364


$
16,828


$
14,216Provision for loan losses


17,233



20,768



5,321Recoveries


577



536



1,833Loans charged off


(12,390
)


(14,768
)


(4,542
)Balance, end of year

$
28,784


$
23,364


$
16,828
 
 93
 Individually impaired loans were as follows for the dates indicated:
 December 31, (In thousands)

2010


2009Year-end loans with no allocated allowance for loan losses

$
58,235


$
47,746Year-end loans with allocated allowance for loan losses


71,785



60,723Total

$
130,020


$
108,469Amount of the allowance for loan losses allocated

$
6,033


$
7,374
  Years Ended December 31, (In thousands)

2010


2009


2008Average of individually impaired loans during year

$
119,596


$
70,845


$
34,364Interest income recognized during impairment


4,022



3,866



1,070Cash-basis interest income recognized


3,933



3,257



880
 
 The following table presents individually impaired loans by class of loans as of December 31, 2010:
 
 Year Ended December 31, 2010 (In thousands)

Recorded

Investment


Unpaid

Principal

Balance


Allowance for

Loan Losses

AllocatedImpaired loans with no related allowance recorded:Real EstateReal estate – construction and land development

$
27,350


$
27,298Real estate mortgage – residential


13,103



13,059Real estate mortgage – farmland and other commercial enterprises


17,895



17,864CommercialCommercial and industrial


14



14Total

$
58,362


$
58,235Impaired loans with an allowance recorded:Real EstateReal estate – construction and land development

$
31,529


$
31,452


$
2,793Real estate mortgage – residential


20,147



19,986



2,051Real estate mortgage – farmland and other commercial enterprises


19,897



19,810



824CommercialCommercial and industrial


447



444



310ConsumerSecured


93



93



55Total

$
72,113


$
71,785


$
6,033
 
 The recorded investment column in the table above excludes immaterial amounts attributed to net deferred loan costs.
 
 The following table presents the balance of the allowance for loan losses and the recorded investment in loans by portfolio segment based on impairment method as of December 31, 2010:
 
 December 31, 2010 (In thousands)

Real Estate


Commercial


Consumer


TotalAllowance for Loan LossesEnding allowance balance attributable to loans:Individually evaluated for impairment

$
5,668


$
310


$
55


$
6,033Collectively evaluated for impairment


18,859



2,950



942



22,751Total ending allowance balance

$
24,527


$
3,260


$
997


$
28,784LoansLoans individually evaluated for impairment

$
129,469


$
458


$
93


$
130,020Loans collectively evaluated for impairment


910,916



123,465



28,439



1,062,820Total ending loan balance, net of unearned income

$
1,040,385


$
123,923


$
28,532


$
1,192,840
 
 Loans in the table above exclude immaterial amounts attributed to accrued interest receivable.
 
 94
 Nonperforming loans were as follows:
 December 31, (In thousands)

2010


2009Nonaccrual loans

$
53,971


$
56,630Restructured loans


36,978



17,911Loans past due 90 days or more and still accruing


42



1,807Total nonperforming loans

$
90,991


$
76,348
 
 The table above excludes immaterial amounts attributed to net deferred loan costs and accrued interest receivable.
 
 The following table presents the recorded investment in nonperforming loans by class of loans as of December 31, 2010:
 
 December 31, 2010 (In thousands)

Nonaccrual


Restructured

Loans


Loans Past

Due 90 Days

or More and

Still AccruingReal Estate:Real estate – construction and land development

$
35,893


$
16,793Real estate mortgage – residential


10,728



9,147


$
28Real estate mortgage – farmland and other commercial enterprises


6,528



11,038Commercial:Commercial and industrial


627Lease financing


50







9Other


31Consumer:Secured


109Unsecured


5







5Total

$
53,971


$
36,978


$
42
 
 The table above excludes immaterial amounts attributed to net deferred loan costs and accrued interest receivable.
 
 The Company has allocated $3,675,000 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of December 31, 2010.  The Company has committed to lend additional amounts totaling up to $46,000 to customers with outstanding loans that are classified as troubled debt restructurings.
  The table below presents an age analysis of past due loans 30 days or more by class of loans as of December 31, 2010. Past due loans that are also classified as nonaccrual are included in their respective past due category.
 
 December 31, 2010 (In thousands)

30-89 Days

Past Due


90 Days

or More

Past Due


Total


Current


Total

LoansReal Estate:Real estate – construction and land development

$
394


$
23,418


$
23,812


$
130,396


$
154,208Real estate mortgage – residential


5,187



7,167



12,354



456,919



469,273Real estate mortgage – farmland and other commercial enterprises


1,595



6,266



7,861



409,043



416,904Commercial:Commercial and industrial


194



538



732



56,297



57,029States and political subdivisions














26,302



26,302Lease financing, net


276



59



335



14,629



14,964Other


114



3



117



25,511



25,628Consumer:Secured


145



102



247



22,360



22,607Unsecured


69



12



81



5,844



5,925Total

$
7,974


$
37,565


$
45,539


$
1,147,301


$
1,192,840
 
 The table above excludes immaterial amounts attributed to net deferred loan costs and accrued interest receivable.
 
 The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends and conditions. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes large-balance loans and
 
 95
 non-homogeneous loans, such as commercial real estate and certain residential real estate loans. Loan rating grades, as described further below, are assigned based on a continuous process. The amount and adequacy of the allowance for loan loss is determined on a quarterly basis. The Company uses the following definitions for its risk ratings:
 
 Special Mention.Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the borrowers repayment ability, weaken the collateral or inadequately protect the Company’s credit position at some future date. These credits pose elevated risk, but their weaknesses do not yet justify a substandard classification.
 
 Substandard.Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.
 
 Doubtful. Loans classified as doubtful have all the weaknesses inherent of those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
 
 Loans not meeting the criteria above which are analyzed individually as part of the above described process are considered to be pass rated loans.  As of December 31, 2010, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:
 
 Real Estate


CommercialDecember 31, 2010

(In thousands)

Real Estate-

Construction

and Land

Development


Real Estate Mortgage-Residential


Real Estate

Mortgage-

Farmland

and Other

Commercial

Enterprises


Commercial

and

Industrial


States and

Political

Subdivisions


Lease

Financing


OtherCredit risk profile by internally assigned rating grades:Pass

$
79,535


$
407,317


$
341,684


$
52,961


$
26,302


$
14,905


$
24,360Special Mention


14,180



18,858



31,747



2,531











1,199Substandard


57,477



41,704



37,938



1,255







59



69Doubtful


3,016



1,394



5,535



282Total

$
154,208


$
469,273


$
416,904


$
57,029


$
26,302


$
14,964


$
25,628
 
 The Company considers the performance of the loan portfolio and its impact on the allowance for loan losses.  For consumer loan classes, the Company also evaluates credit quality based on the aging status of the loan, which was previously presented, and by payment activity.  The following table presents the consumer loans outstanding based on payment activity as of December 31, 2010:
 
 ConsumerDecember 31, 2010 (In thousands)

Secured


UnsecuredCredit risk profile based on payment activity:Performing

$
22,498


$
5,915Nonperforming


109



10Total

$
22,607


$
5,925
 
 Each of the two preceding tables exclude immaterial amounts attributed to accrued interest receivable.
 
 5.
Other Real Estate Owned
 
 OREO was as follows as of the date indicated:
 
 December 31, 2010 (In thousands)

2010


2009Construction and land development

$
18,016


$
17,909Residential real estate


3,203



3,041Farmland and other commercial enterprises


9,326



10,282Total

$
30,545


$
31,232
 
 96
 OREO activity for 2010 and 2009 was as follows:
 
 (In thousands)

2010


2009Beginning balance

$
31,232


$
14,446Transfers from loans


17,771



20,332Transfers from premises






1,506Proceeds from sales


(13,564
)


(3,978
)Loss on sales


(799
)


(366
)Write downs and other decreases, net


(4,096
)


(708
)Ending balance

$
30,544


$
31,232
  6.
Premises and Equipment
 
 Premises and equipment consist of the following.
 December 31, (In thousands)

2010


2009Land, buildings, and leasehold improvements

$
56,744


$
53,324Furniture and equipment


19,935



20,406Total premises and equipment


76,679



73,730Less accumulated depreciation and amortization


(37,067
)


(34,609
)Premises and equipment, net

$
39,612


$
39,121
 
 Depreciation and amortization of premises and equipment was $3,777,000, $3,979,000, and $3,883,000 in 2010, 2009, and 2008, respectively.
 
 7.
Deposit Liabilities
 
 At December 31, 2010 the scheduled maturities of time deposits were as follows.
 (In thousands)

Amount2011

$
425,9852012


177,7702013


65,8912014


28,9802015


8,900Thereafter


6,326Total

$
713,852
 
 Time deposits of $100,000 or more at December 31, 2010 and 2009 were $241,468,000 and $326,832,000, respectively.  Interest expense on time deposits of $100,000 or more was $7,111,000, $11,159,000, and $11,575,000 for 2010, 2009, and 2008, respectively.
 
 Effective in the third quarter 2010, the Federal Deposit Insurance Corporation (“FDIC”) permanently raised its standard maximum insurance amount per depositor from $100,000 to $250,000. At December 31, 2010, the Company had $44,831,000 of time deposits outstanding in amounts of $250,000 or more.
 
 Deposits from directors, executive officers, and principal shareholders (including deposits from affiliated companies of which they are principal owners) and deposits from members of the immediate family of such persons were $19,217,000 and $30,025,000 at December 31, 2010 and 2009, respectively. Such deposits were accepted in the normal course of business on substantially the same terms as those prevailing at the time for comparable transactions with other customers.
 
 8.
Federal Funds Purchased and Other Short-term Borrowings
 
 Federal funds purchased and other short-term borrowings represent borrowings with an original maturity of less than one year. Substantially all of the total short-term borrowings are made up of federal funds purchased and securities sold under agreements to repurchase, which represents borrowings that generally mature one business day following the date of the transaction. Information on federal funds purchased and other short-term borrowings is as follows:
  97
 December 31, (Dollars in thousands)

2010


2009Federal funds purchased and securities sold under agreement to repurchase

$
46,989


$
46,941Other


420



274Total short-term

$
47,409


$
47,215Average balance during the year

$
46,483


$
62,946Maximum month-end balance during the year


76,848



105,844Average interest rate during the year


.70
%


.72
%Average interest rate at year-end


.56



.79
 
 9.
Securities Sold Under Agreements to Repurchase and Other Long-term Borrowings
 
 Long-term securities sold under agreements to repurchase and other borrowings represent borrowings with an original maturity of one year or more. The table below displays a summary of the ending balance and average rate for borrowed funds on the dates indicated.
 Average





AverageDecember 31,  (Dollars in thousands)

2010


Rate


2009


RateFederal Home Loan Bank advances

$
53,155



4.01
%

$
67,630



3.98
%Subordinated notes payable


48,970



4.11



48,970



4.11Securities sold under agreements to repurchase


150,000



3.96



200,000



3.95Other


84



2.32



332



2.32Total long-term

$
252,209



4.00
%

$
316,932



3.98
%
 
 Long-term Federal Home Loan Bank (“FHLB”) advances are made pursuant to several different credit programs, which have their own interest rates and range of maturities. Interest rates on FHLB advances totaling $53,155,000 are fixed and range between 2.60% and 6.90%, averaging 4.01%, over a remaining maturity period of up to 10 years as of December 31, 2010. Long-term FHLB borrowings totaling $35,000,000 at year-end 2010 are putable quarterly. Long-term FHLB advances of $10,000,000 are convertible to a floating interest rate. These advances may convert, at FHLB’s option, to a floating interest rate indexed to the three-month LIBOR only if LIBOR equals or exceeds 7%. At year-end 2010, three-month LIBOR was at .30%.
 
 For FHLB advances, the subsidiary banks pledge FHLB stock and fully disbursed, otherwise unencumbered, 1-4 family first mortgage loans as collateral for these advances as required by the FHLB. Based on this collateral and the Company’s holdings of FHLB stock, the Company is eligible to borrow up to an additional $46,784,000 from the FHLB at year-end 2010.
 
 During 2005 the Company completed two private offerings of trust preferred securities through two separate Delaware statutory trusts sponsored by the Company.  Farmers Capital Bank Trust I (“Trust I”) sold $10,000,000 of preferred securities and Farmers Capital Bank Trust II (“Trust II”) sold $15,000,000 of preferred securities.  The proceeds from the offerings were used to fund the cash portion of the acquisition of Citizens Bancorp, Inc., the former parent company of Citizens Northern.
 
 Farmers Capital Bank Trust III (“Trust III”), a Delaware statutory trust sponsored by the Company, was formed during 2007 for the purpose of financing the cost of acquiring Company shares under a share repurchase program. Trust III sold $22,500,000 of 6.60% (fixed through November 2012, thereafter at a variable rate of interest, reset quarterly, equal to the 3-month LIBOR plus a predetermined spread of 132 basis points) trust preferred securities to the public. The trust preferred securities, which pay interest quarterly, mature on November 1, 2037, may be redeemed by the Trust at par any time on or after November 1, 2012. Trust I, Trust II, and Trust III are hereafter collectively referred to as the “Trusts”.
 
 The Trusts used the proceeds from the sale of preferred securities, plus capital contributed to establish the trusts, to purchase the Company’s subordinated notes in amounts and bearing terms that parallel the amounts and terms of the respective preferred securities.  The subordinated notes to Trust I and Trust II mature in 2035 and in 2037 for Trust III, and bear a floating interest rate (current three-month LIBOR plus 150 basis points in the case of the notes held by Trust I, current three-month LIBOR plus 165 basis points in the case of the notes held by Trust II, and current three-month LIBOR plus 132 basis points in the case of the notes held by Trust III).  Interest on the notes is payable quarterly. Interest payments to the Trusts and distributions to preferred shareholders by the Trusts may be deferred for 20 consecutive quarterly periods.
 
 The subordinated notes are redeemable in whole or in part, without penalty, at the Company’s option on or after September 30, 2010 and mature on September 30, 2035 with respect to Trust I and Trust II.  For Trust III, the subordinated notes are redeemable in whole or in part, without penalty, at the Company’s option on or after November 1, 2012. The notes are junior in right of payment of all present and future senior indebtedness. At December 31, 2010 and 2009 the balance of the subordinated notes payable to Trust I, Trust II, and Trust III was $10,310,000, $15,464,000, and $23,196,000, respectively. The interest rates in effect as of the last determination date in 2010 were 1.79%,
 
 98
 1.94%, and 6.60% for Trust I, Trust II, and Trust III, respectively. For 2009 these rates were 1.78%, 1.93%, and 6.60% for Trust I Trust II, and Trust III, respectively.
 
 The Company is not considered the primary beneficiary of the Trusts; therefore the Trusts are not consolidated into its financial statements. Accordingly, the Company does not report the securities issued by the Trusts as liabilities, but instead reports as liabilities the subordinated notes issued by the Company and held by the Trusts.  The Company, which owns all of the common securities of the Trusts, accounts for its investment in each of the Trusts as assets.  The Company records interest expense on the corresponding notes issued to the Trusts on its statement of income.
 
 The subordinated notes may be included in Tier 1 capital (with certain limitations applicable) under current regulatory capital guidelines and interpretations.  The amount of subordinated notes in excess of the limit may be included in Tier 2 capital, subject to restrictions.
 
 During 2007, the Company entered into a balance sheet leverage transaction whereby it borrowed $200,000,000 in multiple fixed rate term repurchase agreements with an initial weighted average cost of 3.95% and invested the proceeds in Government National Mortgage Association (“GNMA”) bonds, which were pledged as collateral. The Company is required to secure the borrowed funds by GNMA bonds valued at 106% of the outstanding principal balance. The borrowings have an outstanding balance of $150,000,000 at December 31, 2010 with remaining maturities as follows: $50,000,000 due November 2012 and the remaining $100,000,000 due November 2017. At December 31, 2010 $100,000,000 of the borrowings are putable quarterly and the remaining $50,000,000 are putable quarterly beginning in the fourth quarter of 2012. The repurchase agreements are held by each of the Company’s three subsidiary banks that are participating in the transaction and are guaranteed by the Parent Company.
 
 Maturities of long-term borrowings at December 31, 2010 are as follows:
 (In thousands)

Amount2011

$
12,0842012


61,5122013


2,0002014


8,0622015Thereafter


168,551Total

$
252,209
 
 10.
Income Taxes
 
 The components of income tax expense are as follows:
 December 31, (In thousands)

2010


2009


2008Currently payable

$
5,429


$
752


$
832Deferred


(3,392
)


(9,905
)


(2,046
)Total applicable to operations


2,037



(9,153
)


(1,214
)Deferred tax charged (credited) to components of shareholders’ equity:Unfunded status of postretirement benefits


643



(234
)


617Net unrealized securities gains


(2,239
)


841



2,528Total income taxes

$
441


$
(8,546
)

$
1,931
  An analysis of the difference between the effective income tax rates and the statutory federal income tax rate follows.
 December 31,

2010


2009


2008Federal statutory rate


35.0
%


35.0
%


35.0
%Changes from statutory rates resulting from:Tax-exempt interest


(15.3
)


3.0



(48.1
)Nondeductible interest to carry tax-exempt obligations


1.3



(.3
)


5.7Goodwill impairment






(22.7
)Tax credits


(2.5
)


.8



(14.6
)Premium income not subject to tax


(3.9
)


.6



(9.2
)Company-owned life insurance


8.2



.8



(13.5
)Dividend exclusion










(4.8
)Other, net


(.1
)


(.2
)


11.3Effective tax rate on pretax income


22.7
%


17.0
%


(38.2
)%
 
 99
 The tax effects of the significant temporary differences that comprise deferred tax assets and liabilities at December 31, 2010 and 2009 follows.
 December 31, (In thousands)

2010


2009AssetsAllowance for loan losses

$
10,089


$
8,192Deferred directors’ fees


280



269Postretirement benefit obligations


4,159



4,419Other real estate owned


1,150



307Partnership investments


470



337Self-funded insurance


172



167Paid time off


651



712Alternative minimum tax credits






814Low income housing credits






38Intangibles


3,919



4,002Other


60



63Total deferred tax assets


20,950



19,320LiabilitiesDepreciation






360Unrealized gains on available for sale investment securities, net


1,261



3,500Prepaid expenses


647



616Discount on investment securities


1,078



1,098Deferred loan fees


1,041



1,187Lease financing operations


1,372



1,996Total deferred tax liabilities


5,399



8,757Net deferred tax asset

$
15,551


$
10,563
 
 In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized.  The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible.  Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment.  Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not the Company will realize the benefits of these deductible differences at December 31, 2010.
 
 The Company had no unrecognized tax benefits as of December 31, 2010, 2009, and 2008 and did not recognize any increase in unrecognized benefits during 2010 relative to any tax positions taken in 2010. Should the accrual of any interest or penalties relative to unrecognized tax benefits be necessary, it is the Company’s policy to record such accruals in its income tax expense accounts; no such accruals existed as of December 31, 2010, 2009, or 2008. Except as discussed in Note 24 “Subsequent Event”, the Company does not expect any significant changes in its unrecognized tax benefits over the next twelve months. The Company files U.S. federal and various state income tax returns. The Company is no longer subject to income tax examinations by taxing authorities for the years before 2007.
 
 11.
Retirement Plans
 
 The Company maintains a salary savings plan that covers substantially all of its employees. Beginning in 2010, the Company matched voluntary tax deferred employee contributions at 50% of eligible deferrals up to a maximum of 6% of the participants’ compensation. During 2009, the Company matched all eligible voluntary tax deferred employee contributions up to 6% of the participant’s compensation. The Company may, at the discretion of its Board, contribute an additional amount based upon a percentage of covered employees’ salaries. The Company did not make a discretionary contribution during 2010, 2009, or 2008. Discretionary contributions are allocated among participants in the ratio that each participant’s compensation bears to all participants’ compensation. Eligible employees are presented with various investment alternatives related to the salary savings plan. Those alternatives include various stock and bond mutual funds that vary from traditional growth funds to more stable income funds as well as an option to invest in bank certificates of deposits. Company shares are not an available investment alternative in the salary savings plan. The total retirement plan expense for 2010, 2009, and 2008 was $514,000, $1,100,000, and $1,107,000, respectively.
 
 In connection with the acquisition of Citizens Northern, the Company acquired nonqualified supplemental retirement plans for certain key employees. Benefits provided under these plans are unfunded, and payments to plan participants are made by the Company.
 
 100
 The following schedules set forth a reconciliation of the changes in the supplemental retirement plans’ benefit obligation and funded status for the years ended December 31, 2010 and 2009.
 (In thousands)

2010


2009Change in Benefit ObligationObligation at beginning of year

$
565


$
498Service cost


35



34Interest cost


33



30Actuarial loss


29



8Benefit payments


(16
)


(5
)Obligation at end of year

$
646


$
565
 
 The following table provides disclosure of the net periodic benefit cost as of December 31 for the years indicated.
 (In thousands)

2010


2009Service cost

$
35


$
34Interest cost


33



30Recognized net actuarial loss


4



6Net periodic benefit cost

$
72


$
70Major assumptions:Discount rate used to determine net period benefit cost


6.00
%


6.00
%Discount rate used to determine benefit obligation at year end


5.55



6.00
 
 The following table presents estimated future benefit payments in the period indicated.
 (In thousands)

Supplemental Retirement Plan2011

$
272012


272013


272014


272015


272016-2020


165Total

$
300
 
 
 Amounts recognized in accumulated other comprehensive income as of December 31, 2010 and 2009 are as follows:
 (In thousands)

2010


2009Unrecognized net actuarial loss

$
125


$
100Total

$
125


$
100
 
 The estimated cost that will be amortized from accumulated other comprehensive income into net periodic cost over the next fiscal year is as follows:
 (In thousands)

Supplemental Retirement PlanUnrecognized net actuarial loss

$
2Total

$
2
  12.
Common Stock Options
 
 During 1997 the Company’s Board of Directors approved a nonqualified stock option plan (the “Plan”), subsequently approved by the Company’s shareholders, that has provided for the granting of stock options to key employees and officers of the Company.  All stock options are awarded at a price equal to the fair market value of the Company’s common stock at the date options are granted and expire ten years from the grant date. Total options granted were 450,000, 54,000, and 40,049 in the years 1997, 2000, and 2004, respectively.
 
 The Plan provides for the granting of options to purchase up to 450,000 shares of the Company’s common stock at a price equal to the fair market value of the Company’s common stock on the date the option is granted. The term of the options expires after ten years from the date
 
 101
 on which the options are granted. Options granted under the Plan vest ratably over various time periods ranging from three to seven years. All options granted must be held for a minimum of one year before they can be exercised. Forfeited options are available for the granting of additional stock options under the Plan. Options forfeited from the initial grant in 1997 were used to grant options during 2000 and 2004. All outstanding options granted under the Plan are vested. At December 31, 2010 there were 52,172 options available for future grants under the Plan.
 
 A summary of the activity in the Company’s Plan for 2010 is presented below.
 2010WeightedAverageShares


PriceOutstanding at January 1


57,621


$
32.56Expired


(25,572
)


29.75Forfeited


(8,000
)


34.80Outstanding at December 31


24,049


$
34.80Options exercisable at year-end


24,049


$
34.80
 
 Options outstanding at year-end 2010 were as follows:
 Outstanding


ExercisableWeighted

AverageRemaining

Contractual


Weighted

Average





Weighted

AverageExercise Price

Number


Life (Years)


Exercise Price


Number


Exercise Price$34.80


24,049



3.83


$
34.80



24,049


$
34.80
 
 The aggregate intrinsic value for options outstanding and options exercisable at December 31, 2010 was zero since the exercise price of options outstanding was in excess of the market price of the Company’s stock.
 
 The following table presents further information regarding the Company’s stock option Plan during each of the years indicated.
 (In thousands)

2010


2009


2008Tax benefit realized from options exercised

$
0


$
0


$
0Total intrinsic value of options exercised


0



0



1Cash received from options exercised


0



0



30
 
 There were no modifications or cash paid to settle stock option awards during 2010, 2009, or 2008. There were no options granted in 2010, 2009, or 2008.
 
 13.
Postretirement Medical Benefits
 
 Prior to 2003, the Company provided lifetime medical and dental benefits upon retirement for certain employees meeting the eligibility requirements as of December 31, 1989 (Plan 1). During 2003, the Company implemented an additional postretirement health insurance program (Plan 2). Under Plan 2, any employee meeting the service requirement of 20 years of full time service to the Company and is at least age 55 years of age upon retirement is eligible to continue their health insurance coverage. Under both plans, retirees not yet eligible for Medicare have coverage identical to the coverage offered to active employees. Under both plans, Medicare-eligible retirees are provided with a Medicare Advantage plan. The Company pays 100% of the cost of Plan 1. The Company and the retirees each pay 50% of the cost under Plan 2. Both plans are unfunded.
 
 102
 The following schedules set forth a reconciliation of the changes in the plans benefit obligation and funded status for the years ended December 31, 2010 and 2009.
 (In thousands)

2010


2009Change in Benefit ObligationObligation at beginning of year

$
12,524


$
10,550Service cost


396



454Interest cost


607



695Actuarial (gain) loss


(1,523
)


1,104Participant contributions


76



71Benefit payments


(320
)


(350
)Obligation at end of year

$
11,760


$
12,524
 
 The following table provides disclosure of the net periodic benefit cost as of December 31 for the years indicated.
 (In thousands)

2010


2009Service cost

$
397


$
454Interest cost


607



695Amortization of transition obligation


101



101Recognized prior service cost


257



257Recognized net actuarial loss






81Net periodic benefit cost

$
1,362


$
1,588Major assumptions:Discount rate used to determine net periodic benefit cost


6.00
%


6.00
%Discount rate used to determine benefit obligation as of year end


5.55



6.00Retiree participation rate (Plan 1)


100.00



100.00Retiree participation rate (Plan 2)


72.00



72.00
 
 Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. For measurement purposes, the rate of increase in pre-Medicare medical care claims costs was 9%, 8%, and 7% in 2011, 2012, and 2013, respectively, then grading down by .5% annually to 5% for 2017 and thereafter. For dental claims cost, it was 5% for 2011 and thereafter. A 1% change in the assumed health care cost trend rates would have the following incremental effects:
 (In thousands)

1% Increase


1% DecreaseEffect on total of service and interest cost components of net periodic postretirement health care benefit cost

$
238


$
(183
)Effect on accumulated postretirement benefit obligation


2,225



(1,766
)
 
 The following table presents estimated future benefit payments in the period indicated.
 (In thousands)

Postretirement Medical Benefits2011

$
3712012


3752013


4062014


4472015


4572016-2020


2,815Total

$
4,871
 
 Amounts recognized in accumulated other comprehensive income as of December 31, 2010 and 2009 are as follows:
 (In thousands)

2010


2009Unrecognized net actuarial loss

$
719


$
2,242Unrecognized transition obligation


203



305Unrecognized prior service cost


1,153



1,410Total

$
2,075


$
3,957
 
 103
 The estimated costs that will be amortized from accumulated other comprehensive income into net periodic cost over the next fiscal year are as follows.
 (In thousands)

Postretirement Medical BenefitsTransition obligation

$
101Unrecognized prior service cost


257Total

$
358
 
 14.
Leases
 
 The Company leases certain branch sites and banking equipment under various operating leases. Branch site leases have renewal options of varying lengths and terms. In addition, the Company leases certain data processing equipment that meets the capitalization criteria of ASC Topic 840, “Leases”, and has been recorded as an asset in premises and equipment and a liability in other long-term debt on the balance sheet. The following table presents estimated future minimum rental commitments under these leases for the period indicated.
 (In thousands)

Operating

Leases


Capital

Lease2011

$
451


$
842012


4132013


3902014


3822015


343Thereafter


1,925Total

$
3,904



84Less: amount representing interest






1Long-term obligation under capital lease





$
83
 
 Rent expense was $568,000, $772,000, and $748,000 for 2010, 2009, and 2008, respectively.
 
 15.
Financial Instruments With Off-Balance Sheet Risk
 
 The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. The financial instruments include commitments to extend credit and standby letters of credit.
 
 These financial instruments involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract amounts of these instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
 
 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 the payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. Total commitments to extend credit were $126,764,000 and $139,538,000 at December 31, 2010 and 2009, respectively. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained upon extension of credit, if deemed necessary by the Company, is based on management’s credit evaluation of the counter-party. Collateral held varies, but may include accounts receivable, marketable securities, inventory, premises and equipment, residential real estate, and income producing commercial properties.
 
 Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Since many of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. The credit risk involved in issuing letters of credit is essentially the same as that received when extending credit to customers. The fair value of these instruments is not considered material for disclosure. The Company had $18,068,000 and $18,121,000 in irrevocable letters of credit outstanding at December 31, 2010 and 2009, respectively.
 
 The contractual amount of financial instruments with off-balance sheet risk was as follows at year-end.
 December 31,

2010


2009(In thousands)

Fixed Rate


Variable Rate


Fixed Rate


Variable RateCommitments to extend credit, including unused lines of credit

$
45,695


$
81,069


$
35,646


$
103,892Standby letters of credit


3,893



14,175



3,812



14,309Total

$
49,588


$
95,244


$
39,458


$
118,201
  104
 16.
Concentration of Credit Risk
  The Company’s bank subsidiaries actively engage in lending, primarily in their home counties around central and northern Kentucky and adjacent areas. Collateral is received to support these loans as deemed necessary. The more significant categories of collateral include cash on deposit with the Company’s banks, marketable securities, income producing properties, commercial real estate, home mortgages, and consumer durables. Loans outstanding, commitments to make loans, and letters of credit range across a large number of industries and individuals. The obligations are significantly diverse and reflect no material concentration in one or more areas, other than most of the Company’s loans are in Kentucky and secured by real estate and thus significantly affected by changes in the Kentucky economy.
 
 17.
Loss Contingencies
 
 Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. As of December 31, 2010, there were various pending legal actions and proceedings against the Company arising from the normal course of business and in which claims for damages are asserted. Management, after discussion with legal counsel, believes that these actions are without merit and that the ultimate liability resulting from these legal actions and proceedings, if any, will not have a material effect upon the consolidated financial statements of the Company.
 
 18.
Regulatory Matters
 
 The Company and its subsidiary banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements will initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the banks must meet specific capital guidelines that involve quantitative measures of the banks’ assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company and its subsidiary banks’ capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
 
 Quantitative measures established by regulation to ensure capital adequacy require the Company and its subsidiary banks to maintain minimum amounts and ratios (set forth in the tables below) of Tier 1 and total capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital to average assets (as defined). As of December 31, 2010, the most recent notification from the FDIC categorized the banks as well-capitalized under the regulatory framework for prompt corrective action. To be categorized as well-capitalized, the banks must maintain minimum Tier 1 Risk-based, Total Risk-based, and Tier 1 Leverage ratios as set forth in the tables. There are no conditions or events since that notification that management believes have changed the institutions’ category. As noted below under the caption “Summary of Regulatory Agreements”, three of the Company’s subsidiary banks are required to maintain certain capital ratios that exceed the regulatory established well-capitalized status.
 
 105
 
 The regulatory capital amounts and ratios of the consolidated Company and its subsidiary banks are presented in the following tables for the dates indicated. The capital amounts and ratios for Farmers Bank as of December 31, 2009 have been revised to reflect its merger with Lawrenceburg Bank that closed during the second quarter of 2010. Lawrenceburg Bank was a wholly-owned subsidiary of the Parent Company until it merged with Farmers Bank.
 To Be Well-CapitalizedFor Capital


Under Prompt CorrectiveActual


Adequacy Purposes


Action ProvisionsDecember 31, 2010 (Dollars in thousands)

Amount


Ratio


Amount


Ratio


Amount


RatioTier 1 Risk-based Capital1Consolidated

$
187,237



15.35
%

$
48,794



4.00
%


N/A



N/AFarmers Bank & Capital Trust Company


66,013



15.59



16,935



4.00


$
25,402



6.00
%First Citizens Bank


25,969



12.76



8,143



4.00



12,214



6.00United Bank & Trust Company


51,347



12.91



15,908



4.00



23,863



6.00Citizens Bank of Northern Kentucky, Inc.


20,552



11.42



7,196



4.00



10,795



6.00Total Risk-based Capital1Consolidated

$
202,652



16.61
%

$
97,588



8.00
%


N/A



N/AFarmers Bank & Capital Trust Company


71,386



16.86



33,870



8.00


$
42,337



10.00
%First Citizens Bank


27,481



13.50



16,286



8.00



20,357



10.00United Bank & Trust Company


56,408



14.18



31,817



8.00



39,771



10.00Citizens Bank of Northern Kentucky, Inc.


22,812



12.68



14,393



8.00



17,991



10.00Tier 1 Leverage Capital2Consolidated

$
187,237



9.39
%

$
79,761



4.00
%


N/A



N/AFarmers Bank & Capital Trust Company


66,013



8.55



30,868



4.00


$
38,586



5.00
%First Citizens Bank


25,969



8.46



12,285



4.00



15,356



5.00United Bank & Trust Company


51,347



8.24



24,935



4.00



31,168



5.00Citizens Bank of Northern Kentucky, Inc.


20,552



8.04



10,227



4.00



12,784



5.00
 
 1
Tier 1 Risk-based and Total Risk-based Capital ratios are computed by dividing a bank’s Tier 1 or Total Capital, as defined by regulation, by a risk-weighted sum of the bank’s assets, with the risk weighting determined by general standards established by regulation. The safest assets (e.g., government obligations) are assigned a weighting of 0% with riskier assets receiving higher ratings (e.g., ordinary commercial loans are assigned a weighting of 100%).
 
 2
Tier 1 Leverage ratio is computed by dividing a bank’s Tier 1 Capital, as defined by regulation, by its total quarterly average assets.
  To Be Well-CapitalizedFor Capital


Under Prompt CorrectiveActual


Adequacy Purposes


Action ProvisionsDecember 31, 2009 (Dollars in thousands)

Amount


Ratio


Amount


Ratio


Amount


RatioTier 1 Risk-based Capital1Consolidated

$
185,874



13.95
%

$
53,310



4.00
%


N/A



N/AFarmers Bank & Capital Trust Co.


61,767



13.22



18,691



4.00


$
28,037



6.00
%First Citizens Bank


24,295



12.02



8,082



4.00



12,124



6.00United Bank & Trust Co.


56,376



12.49



18,051



4.00



27,077



6.00Citizens Bank of Northern Kentucky


18,443



9.70



7,606



4.00



11,049



6.00Total Risk-based Capital1Consolidated

$
202,616



15.20
%

$
106,620



8.00
%


N/A



N/AFarmers Bank & Capital Trust Co.


67,664



14.48



37,382



8.00


$
46,728



10.00
%First Citizens Bank


25,787



12.76



16,165



8.00



20,206



10.00United Bank & Trust Co.


62,051



13.75



36,103



8.00



45,128



10.00Citizens Bank of Northern Kentucky


20,829



10.95



15,213



8.00



19,016



10.00Tier 1 Leverage Capital2Consolidated

$
185,874



8.15
%

$
91,186



4.00
%


N/A



N/AFarmers Bank & Capital Trust Co.


61,767



7.05



35,049



4.00


$
43,811



5.00
%First Citizens Bank


24,295



7.96



12,214



4.00



15,268



5.00United Bank & Trust Co.


56,376



7.35



30,673



4.00



38,342



5.00Citizens Bank of Northern Kentucky


18,443



6.23



11,839



4.00



14,799



5.00
 
 1
Tier 1 Risk-based and Total Risk-based Capital ratios are computed by dividing a bank’s Tier 1 or Total Capital, as defined by regulation, by a risk-weighted sum of the bank’s assets, with the risk weighting determined by general standards established by regulation. The safest assets (e.g., government obligations) are assigned a weighting of 0% with riskier assets receiving higher ratings (e.g., ordinary commercial loans are assigned a weighting of 100%).
 
 2
Tier 1 Leverage ratio is computed by dividing a bank’s Tier 1 Capital, as defined by regulation, by its total quarterly average assets.
 
 106
 
 Payment of dividends by the Company’s subsidiary banks is subject to certain regulatory restrictions as set forth in national and state banking laws and regulations. Generally, capital distributions are limited to undistributed net income for the current and prior two years, subject to the capital requirements as summarized above. At December 31, 2010, three of the Company’s subsidiary banks are required to obtain regulatory approval before declaring or paying a dividend to the Parent Company as a result of agreements that were entered into with their primary regulator. The payment of dividends by the Parent Company to its shareholders is also subject to approval as a result of regulatory agreement. The regulatory agreements, which are summarized below, also require three of the Company’s subsidiary banks to maintain capital ratios that exceed the regulatory established well-capitalized status.
 
 Summary of Regulatory Agreements
 
 Below is a summary of the regulatory agreements that the Parent Company and three of its subsidiary banks have entered into with their primary regulators. For a more complete discussion and additional information regarding these regulatory actions, please refer to the section captioned “Capital Resources” under Item 7 “Management’s Discussion and Analysis of Financial Condition and Result of Operations” part of this Form 10-K.
 
 Parent Company
 
 In the summer of 2009 the Federal Reserve Bank of St. Louis (“FRB St. Louis”) conducted an examination of the Parent Company.  Primarily due to the regulatory actions and capital requirements at three of the Company’s subsidiary banks (as discussed below), the FRB St. Louis and Kentucky Department of Financial Institutions (“KDFI”) proposed the Company enter into a Memorandum of Understanding (“Memorandum”).  The Company’s board approved entry into the Memorandum at a regular board meeting during the fourth quarter of 2009.  Pursuant to the Memorandum, the Company agreed that it would develop an acceptable capital plan to ensure that the consolidated organization remains well-capitalized and each of its subsidiary banks meet the capital requirements imposed by their regulator as summarized below.
 
 The Company also agreed to reduce its common stock dividend in the fourth quarter of 2009 from $.25 per share down to $.10 per share and not make interest payments on the Company’s trust preferred securities or dividends on its common or preferred stock without prior approval from FRB St. Louis and KDFI.  Representatives of the FRB St. Louis and KDFI have indicated that any such approval for the payment of dividends will be predicated on a demonstration of adequate, normalized earnings on the part of the Company’s subsidiaries sufficient to support quarterly payments on the Company’s trust preferred securities and quarterly dividends on the Company’s common and preferred stock.  While both regulatory agencies have granted approval of all subsequent quarterly Company requests to make interest payments on its trust preferred securities and dividends on its preferred stock, the Company has not (based on the assessment by Company management of both the Company’s capital position and the earnings of its subsidiaries) sought regulatory approval for the payment of common stock dividends since the fourth quarter of 2009.  Moreover, the Company will not pay any such dividends on its common stock in any subsequent quarter until the regulator’s assessment of the earnings of the Company’s subsidiaries, and the Company’s assessment of its capital position, both yield the conclusion that the payment of a Company common stock dividend is warranted.
 
 Other components in the regulatory order for the parent company include requesting and receiving regulatory approval for the payment of new salaries/bonuses or other compensation to insiders; assisting its subsidiary banks in addressing weaknesses identified in their reports of examinations; providing periodic reports detailing how it will meet its debt service obligations; and providing progress reports with its compliance with the regulatory Memorandum.
 
 Farmers Bank.  Farmers Bank was the subject of a regularly scheduled examination by the KDFI which was conducted in mid-September 2009.  As a result of this examination, the KDFI and FRB St. Louis entered into a Memorandum with Farmers Bank.  The Memorandum requires that Farmers Bank obtain written consent prior to declaring or paying the Parent Company a cash dividend and to achieve and maintain a Tier 1 Leverage ratio of 8.0% by June 30, 2010.  The Parent Company injected from its reserves $11 million in capital into Farmers Bank subsequent to the Memorandum.
 
 At June 30, 2010, Farmers Bank had a Tier 1 Leverage ratio of 7.98% and a Total Risk-based Capital ratio of 15.78%. Subsequent to June 30, 2010, the Parent Company injected into Farmers Bank an additional $200 thousand in capital in order to raise its Tier 1 Leverage ratio to 8.0% to comply with the Memorandum. At December 31, 2010 Farmers Bank had a Tier 1 Leverage ratio of 8.55% and a Total Risk-based Capital ratio of 16.86%.
 
 Other parts of the regulatory order include the development and documentation of plans for reducing problem loans, providing progress reports on compliance with the Memorandum, developing and implementing a written profit plan and strategic plans, and evaluating policies and procedures for monitoring construction loans and use of interest reserves. It also restricts the bank from extending additional credit to borrowers with credits classified as substandard, doubtful or special mention in the report of examination.
 
 107
 
 Lawrenceburg Bank. As a result of an examination conducted in March 2009, on May 15, 2009, Lawrenceburg Bank entered into a Memorandum with the FRB St. Louis and the KDFI. This Memorandum terminated effective upon Lawrenceburg Bank’s merger into Farmers Bank on May 8, 2010.
 
 United Bank.  As a result of an examination conducted in late July and early August of 2009, the Federal Deposit Insurance Corporation (“FDIC”) proposed United Bank enter into a Cease and Desist Order (“Order”) primarily as a result of its level of nonperforming assets.  The Order requires United Bank to obtain written consent prior to declaring or paying the Parent Company a cash dividend and achieve and maintain a Tier 1 Leverage ratio of 8.0% by June 30, 2010 and a Total Risk-based Capital ratio of 12% immediately.   Subsequent to the Order, the Parent Company injected $10.5 million from its reserves into United Bank. In April 2010, the Parent Company injected an additional $1.9 million of capital into United Bank to bring its Tier 1 Leverage ratio up to the minimum 7.75% as of March 31, 2010 as required by the Order.  At June 30, 2010, United Bank had a Tier 1 Leverage ratio of 8.06% and a Total Risk-based Capital ratio of 14.12%. At December 31, 2010, United Bank had a Tier 1 Leverage ratio of 8.24% and a Total Risk-based Capital ratio of 14.18%.
 
 Other components in the regulatory order include stricter oversight and reporting to its regulators in terms of complying with the Order. It also includes an increase in the level of reporting by management to its board of directors of its financial results, budgeting, and liquidity analysis, as well as restricting the bank from extending additional credit to borrowers with credits classified as substandard, doubtful or special mention in the report of examination.
 
 Citizens Northern.  Citizens Northern was the subject of a regularly scheduled examination by the KDFI which was completed in late May 2010.  As a result of this examination, the KDFI and the FDIC on September 8, 2010 entered into a Memorandum with Citizens Northern.  The Memorandum requires that Citizens Northern obtain written consent prior to declaring or paying a dividend and to increase Tier 1 Leverage ratio to equal or exceed 7.5% prior to September 30, 2010 and to achieve and maintain Tier 1 Leverage ratio to equal or exceed 8.0% prior to December 31, 2010.  In December 2010, the Parent Company injected $250 thousand of capital into Citizens Northern to bring its Tier 1 Leverage ratio up to the minimum 8.0% as of year-end 2010 as required by the Order.  At December 31, 2010, Citizens Northern had a Tier 1 Leverage ratio of 8.04% and a Total Risk-based Capital ratio of 12.68%.
 
 Other parts of the regulatory order include the development and documentation of plans for reducing problem loans, providing progress reports on compliance with the Memorandum, and for the development and implementation of a written profit plan and strategic plans. It also restricts the bank from extending additional credit to borrowers with credits classified as substandard, doubtful or special mention in the report of examination.
 
 At the Parent Company and at each of its bank subsidiaries, the Company believes it is adequately addressing all issues of the regulatory agreements to which it is subject. However, only the respective regulatory agencies can determine if compliance with the applicable regulatory agreements have been met. The Company and its subsidiary banks are in compliance with the requirements identified in the regulatory agreements as of December 31, 2010, with the exception that the level of substandard loans at Farmers Bank exceed the target amount by $1.3 million. Regulators continue to monitor the Company’s progress and compliance with the agreements through periodic on-site examinations, regular communications, and quarterly data analysis. The results of these examinations and communications show satisfactory progress toward meeting the requirements included in the regulatory agreements.
 
 The Parent Company maintains cash available to fund a certain amount of additional injections of capital to its bank subsidiaries if required by its regulators. If needed, further amounts in excess of available cash may be funded by future public or private sales of securities, although the Parent Company is currently under no directive by its regulators to raise any additional capital.
  19.
Fair Value Measurements
  ASC Topic 820, “Fair Value Measurements and Disclosures”, defines fair value, establishes a framework for measuring fair value, and sets forth disclosures about fair value measurements. ASC Topic 825, “Financial Instruments”, allows entities to choose to measure certain financial assets and liabilities at fair value. The Company has not elected the fair value option for any of its financial assets or liabilities.
 
 ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. It also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. This Topic describes three levels of inputs that may be used to measure fair value:
 
 Level 1:
Quoted prices for identical assets or liabilities in active markets that the entity has the ability to access at the measurement date.
  108
  Level 2:
Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
 
 Level 3:
Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability.
 
 Following is a description of the valuation method used for instruments measured at fair value on a recurring basis. For this disclosure, the Company only has available for sale investment securities that meet the requirement.
 
 Available for sale investment securities
 Valued primarily by independent third party pricing services under the market valuation approach that include, but not limited to, the following inputs:
 
 ·
U.S. Treasury securities are priced using dealer quotes from active market makers and real-time trading systems.
 ·
Marketable equity securities are priced utilizing real-time data feeds from active market exchanges for identical securities.
 ·
Government-sponsored agency debt securities, obligations of states and political subdivisions, corporate bonds, and other similar investment securities are priced with available market information through processes using benchmark yields, matrix pricing, prepayment speeds, cash flows, live trading data, and market spreads sourced from new issues, dealer quotes, and trade prices, among others sources.
 
 Available for sale investment securities are the Company’s only balance sheet item that meets the disclosure requirements for instruments measured at fair value on a recurring basis. Disclosures as of December 31, 2010 and 2009 are as follows:
 
 Fair Value Measurements Using(In thousands)



Available For Sale Investment Securities

Fair Value


Quoted Prices in

Active Markets

for Identical

Assets

(Level 1)


Significant

Other

Observable Inputs

(Level 2)


Significant

Unobservable

Inputs

(Level 3)December 31, 2010U.S. Treasury securities

$
1,044


$
1,044Obligations of U.S. government-sponsored entities


41,613






$
41,613Obligations of states and political subdivisions


74,799







74,799Mortgage-backed securities – residential


319,930







319,930Money market mutual funds


145



145Corporate debt securities


6,606







6,606Equity securities


45



45Total

$
444,182


$
1,234


$
442,948


$
0December 31, 2009U.S. Treasury securities

$
3,002


$
3,002Obligations of U.S. government-sponsored entities


90,752






$
90,752Obligations of states and political subdivisions


108,958







108,958Mortgage-backed securities – residential


325,519







325,519Money market mutual funds


910



910Corporate debt securities


18,732







18,732Total

$
547,873


$
3,912


$
543,961


$
0
 
 The Company is required to measure and disclose certain other assets and liabilities at fair value on a nonrecurring basis to comply with GAAP, The Company’s disclosure about assets and liabilities measured at fair value on a nonrecurring basis consists of impaired loans and OREO.
 
 Impaired loans were $130 million and $108 million at year-end 2010 and 2009, respectively. Impaired loans at December 31, 2010 include $17.7 million that were written down to their estimated fair value of $16.7 million, resulting in an impairment charge of $943 thousand included in the provision for loan losses and the allowance for loan losses. At December 31, 2009, impaired loans included $60.7 million that were written down to their estimated fair value of $55.0 million, resulting in an impairment charge of $5.8 million included in the provision
 
 109
 
 and allowance for loan losses. The fair value of impaired loans with specific allocations of the allowance for loan losses is measured based on recent appraisals of the underlying collateral. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraisers take absorption rates into consideration and adjustments are routinely made in the appraisal process to identify differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.OREO includes properties acquired by the Company through actual loan foreclosures and is carried at fair value less estimated costs to sell. Fair value of OREO is generally based on third party appraisals of the property that includes comparable sales data and is considered as Level 3 inputs. If the carrying amount of the OREO exceeds fair value less estimated costs to sell, an impairment loss is recorded through expense. At December 31, 2010 and December 31, 2009 OREO was $30.5 million and $31.2 million, respectively. OREO at year-end 2010 includes $19.7 million that was written down to its estimated fair value of $15.8 million, resulting in an impairment charge of $3.9 million included in earnings. For year-end 2009, OREO includes $12.0 million that was written down to its estimated fair value of $11.1 million, resulting in an impairment charge of $877 thousand included in earnings. In addition to impairment charges, net losses included in earnings from the sale of OREO were $799 thousand and $366 thousand for 2010 and 2009, respectively.
 
 The following table represents the carrying amount of assets measured at fair value on a nonrecurring basis for the dates indicated and the related impairment charges recorded in earnings.
 
 Fair Value Measurements Using(In thousands)





Description

Fair Value

Quoted Prices in

Active Markets for

Identical Assets

(Level 1)
Significant Other

Observable

Inputs

(Level 2)

Significant

Unobservable

Inputs

(Level 3)


Impairment

ChargeDecember 31, 2010Impaired LoansReal estate-construction and land development

$
12,573




$
12,573


$
52Real estate mortgage-residential


10,376





10,376



359Real estate mortgage-farmland and other commercial enterprises


9,331





9,331



505Commercial and industrial


133





133



27Consumer-secured


38





38Total-Impaired Loans

$
32,451




$
32,451


$
943OREOReal estate-construction and land development

$
12,381




$
12,381


$
3,144Real estate mortgage-residential


630





630



294Real estate mortgage-farmland and other commercial enterprises


2,810





2,810



428Total-OREO

$
15,821




$
15,821


$
3,866December 31, 2009Impaired loans

$
54,961




$
54,961


$
5,762OREO


11,140





11,140



877Total

$
66,101




$
66,101


$
6,639
 
 Fair Value of Financial Instruments
 
 The table that follows represents the estimated fair values of the Company’s financial instruments made in accordance with the requirements of ASC 825, “Financial Instruments”. ASC 825 requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet for which it is practicable to estimate that value. The estimated fair value amounts have been determined by the Company using available market information and present value or other valuation techniques. These derived fair values are subjective in nature, involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. ASC 825 excludes certain financial instruments and all nonfinancial instruments from the disclosure requirements. Accordingly, the aggregate fair value amounts presented are not intended to represent the underlying value of the Company.
 
 110
 
 The following methods and assumptions were used to estimate the fair value of each class of financial instruments not presented elsewhere for which it is practicable to estimate that value.
 
 Cash and Cash Equivalents, Accrued Interest Receivable, and Accrued Interest Payable
 The carrying amount is a reasonable estimate of fair value.
 
 Investment Securities Held to Maturity
 Fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.
 
 FHLB and Similar Stock
 Due to restrictions placed on its transferability, it is not practicable to determine fair value.
 
 Loans
 The fair value of loans is estimated by discounting the future cash flows using current discount rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.
 
 Deposit Liabilities
 The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date and fair value approximates carrying value. The fair value of fixed maturity certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for certificates of deposit with similar remaining maturities.
 
 Federal Funds Purchased and other Short-term Borrowings
 The carrying amount is the estimated fair value for these borrowings that reprice frequently in the near term.
 
 Securities Sold Under Agreements to Repurchase, Subordinated Notes Payable, and Other Long-term Borrowings
 The fair value of these borrowings is estimated based on rates currently available for debt with similar terms and remaining maturities.
 
 Commitments to Extend Credit and Standby Letters of Credit
 Pricing of these financial instruments is based on the credit quality and relationship, fees, interest rates, probability of funding, compensating balance, and other covenants or requirements. Loan commitments generally have fixed expiration dates, variable interest rates and contain termination and other clauses that provide for relief from funding in the event there is a significant deterioration in the credit quality of the customer. Many loan commitments are expected to, and typically do, expire without being drawn upon. The rates and terms of the Company’s commitments to lend and standby letters of credit are competitive with others in the various markets in which the Company operates. There are no unamortized fees relating to these financial instruments, as such the carrying value and fair value are both zero.
 
 111
 
 The carrying amounts and estimated fair values of the Company’s financial instruments are as follows for the dates indicated.
 December 31,

2010


2009(In thousands)

Carrying

Amount


Fair

Value


Carrying

Amount


Fair

ValueAssetsCash and cash equivalents

$
182,056


$
182,056


$
218,336


$
218,336Investment securities:Available for sale


444,182



444,182



547,873



547,873Held to maturity


930



844



975



922FHLB and similar stock


9,515



N/A



9,148



N/ALoans, net


1,164,056



1,157,606



1,248,578



1,246,151Accrued interest receivable


7,258



7,258



9,381



9,381LiabilitiesDeposits


1,463,572



1,470,277



1,633,433



1,640,933Federal funds purchased and other short-term borrowings


47,409



47,409



47,215



47,215Securities sold under agreements to repurchase and other long-term borrowings


203,239



219,709



267,962



285,093Subordinated notes payable to unconsolidated trusts


48,970



27,234



48,970



28,528Accrued interest payable


2,811



2,811



4,685



4,685
 
 
 20.  Parent Company Financial Statements
 
 Condensed Balance Sheets
 December 31, (In thousands)

2010


2009AssetsCash and cash equivalents

$
16,249


$
7,554Investment in subsidiaries


183,158



180,367Other assets


3,752



11,392Total assets

$
203,159


$
199,313LiabilitiesDividends payable

$
188


$
925Subordinated notes payable to unconsolidated trusts


48,970



48,970Other liabilities


4,105



2,191Total liabilities


53,263



52,086Shareholders’ EquityPreferred stock


28,719



28,348Common stock


926



922Capital surplus


50,675



50,476Retained earnings


68,678



63,617Accumulated other comprehensive income


898



3,864Total shareholders’ equity


149,896



147,227Total liabilities and shareholders’ equity

$
203,159


$
199,313
  112
 
 Condensed Statements of Operations
 Years Ended December 31, (In thousands)

2010


2009


2008IncomeDividends from subsidiaries

$
6,627


$
7,465


$
9,566Interest


12



53



60Other noninterest income


3,637



3,457



3,217Total income


10,276



10,975



12,843ExpenseInterest expense-subordinated notes payable to unconsolidated trusts


2,035



2,178



2,865Interest expense on other borrowed funds


2Noninterest expense


3,689



4,097



3,986Total expense


5,726



6,275



6,851Income before income tax expense (benefit) and equity in undistributed income of subsidiaries


4,550



4,700



5,992Income tax expense (benefit)


411



(949
)


(1,189
)Income before equity in undistributed income of subsidiaries


4,139



5,649



7,181Equity in undistributed income (loss) of subsidiaries


2,793



(50,391
)


(2,786
)Net income (loss)

$
6,932


$
(44,742
)

$
4,395
 
 
 Condensed Statements of Cash Flows
 Years Ended December 31, (In thousands)

2010


2009


2008Cash Flows From Operating ActivitiesNet income (loss)

$
6,932


$
(44,742
)

$
4,395Adjustments to reconcile net income (loss) to net cash provided by operating activities:Equity in undistributed (income) loss of subsidiaries


(2,793
)


50,391



2,786Noncash stock option expense and employee stock purchase plan expense


2



5



5Change in other assets and liabilities, net


1,917



(1,043
)


(891
)Deferred income tax (benefit) expense


(850
)


253



(67
)Net cash provided by operating activities


5,208



4,864



6,228Cash Flows From Investing ActivitiesProceeds from sale of available for sale investment securities










1,000Purchase of available for sale investment securities










(1,000
)Return of equity from nonbank subsidiary


1,150Investment in nonbank subsidiaries


(800
)


(100
)


(4,051
)Investment in bank subsidiaries


(3,350
)


(22,500
)


(2,362
)Proceeds from liquidation of company-owned life insurance


8,567Net cash provided by (used in) investing activities


5,567



(22,600
)


(6,413
)Cash Flows From Financing ActivitiesProceeds from issuance of preferred stock, net of issue costs






29,961Dividends paid, common and preferred stock


(2,237
)


(9,222
)


(9,720
)Purchase of common stock










(1,049
)Shares issued under Employee Stock Purchase Plan


157



249



252Stock options exercised










30Net cash (used in) provided by financing activities


(2,080
)


20,988



(10,487
)Net increase (decrease) in cash and cash equivalents


8,695



3,252



(10,672
)Cash and cash equivalents at beginning of year


7,554



4,302



14,974Cash and cash equivalents at end of year

$
16,249


$
7,554


$
4,302
  113
 
 21.
Quarterly Financial Data (Unaudited)
 (In thousands, except per share data)Quarters Ended 2010

March 31


June 30


Sept. 30


Dec. 31Interest income

$
23,382


$
23,475


$
22,105


$
20,789Interest expense


9,932



9,198



8,478



7,340Net interest income


13,450



14,277



13,627



13,449Provision for loan losses


1,926



5,490



6,244



3,573Net interest income after provision for loan losses


11,524



8,787



7,383



9,876Noninterest income


7,490



9,869



10,324



6,427Noninterest expense


16,497



15,205



15,927



15,082Income before income taxes


2,517



3,451



1,780



1,221Income tax expense


572



610



525



330Net income


1,945



2,841



1,255



891Dividends and accretion on preferred shares


(466
)


(466
)


(469
)


(470
)Net income available to common shareholders

$
1,479


$
2,375


$
786


$
421Net income per common share, basic and diluted

$
.20


$
.32


$
.11


$
.06Weighted average shares outstanding, basic and diluted


7,379



7,384



7,393



7,402
  
 (In thousands, except per share data)Quarters Ended 2009

March 31


June 30


Sept. 30


Dec. 31Interest income

$
26,329


$
25,479


$
25,381


$
23,721Interest expense


12,090



12,076



11,879



11,020Net interest income


14,239



13,403



13,502



12,701Provision for loan losses


1,676



5,940



6,653



6,499Net interest income after provision for loan losses


12,563



7,463



6,849



6,202Noninterest income


6,725



7,825



6,528



7,091Noninterest expense1


15,112



16,163



15,299



68,567Income (loss) before income taxes


4,176



(875
)


(1,922
)


(55,274
)Income tax expense (benefit)


871



(74
)


(1,748
)


(8,202
)Net income (loss)2


3,305



(801
)


(174
)


(47,072
)Dividends and accretion on preferred shares


(414
)


(462
)


(462
)


(464
)Net income (loss) available to common shareholders

$
2,891


$
(1,263
)

$
(636
)

$
(47,536
)Net income (loss) per common share, basic and diluted

$
.39


$
(.17
)

$
(.09
)

$
(6.45
)Weighted average shares outstanding, basic and diluted


7,357



7,363



7,367



7,371
 
 1
Noninterest expense for the quarter ended December 31, 2009 includes a one-time, non-cash goodwill impairment charge of $52,408.
 2
The net loss for the quarters ended June 30, 2009 and September 30, 2009 is due mainly to an increase in the provision for loans losses which is attributable to higher levels of nonperforming assets, primarily nonaccrual loans secured by real estate developments.
 
 22.  Goodwill and Intangible Assets
 
 Goodwill
 
 The change in the balance of goodwill is presented in the table below. The Company wrote off the entire amount of its previously existing goodwill amount during the fourth quarter of 2009 after determining that it was impaired.
 (In thousands)

2010


2009


2008Beginning of year

$
0


$
52,408


$
52,408Impairment losses






(52,408
)End of year

$
0


$
0


$
52,408
 
 The Company’s last goodwill impairment evaluation was performed during the fourth quarter of 2009. Goodwill impairment exists when a Company’s reporting unit’s carrying value of goodwill exceeds its fair value. The Company uses a two-step impairment test whereby Step 1 is to determine if potential impairment exists by comparing the estimated fair value of the Company’s single reporting unit to its carrying value, including goodwill. The second step of the impairment test is necessary only if the carrying value of the reporting unit exceeds its estimated fair value. Step 2 measures the amount of any impairment loss. This step compares the implied fair value of the Company’s goodwill with its carrying amount. If the carrying amount of goodwill exceeds its implied fair value, an impairment loss is recorded in an amount equal to that excess. The loss recognized cannot exceed the carrying amount of goodwill.
 
 114
 
 The Company’s common share price declined $14.20 or 58.1% on December 31, 2009 compared to December 31, 2008. The decrease was $8.75 or 35.8% during the first quarter before rebounding to $25.17 at the end of the second quarter, an increase of $9.50 or 60.6% for the quarter. The share price further declined to $17.88 and $10.22 at the end of the third and fourth quarters of 2009, respectively. The stock price and market capitalization of the Company as well as other peer banks and financial institutions suffered during that time as a result of continuing economic weaknesses and heightened market concern surrounding the credit risk and market capital positions of the overall financial institutions’ industry. The Company concluded during the fourth quarter of 2009 that these events would more likely than not reduce the fair value of its single reporting unit below the carrying value.
 
 December 31,

2009


September 30,

2009


June 30,

2009


March 31,

2009


December 31,

2008Stock price at end of period

$
10.22


$
17.88


$
25.17


$
15.67


$
24.42Weighted average closing stock price for quarter


11.64



20.23



21.36



17.80



22.07Book value per common share


16.11



23.13



22.60



23.08



22.87
 The Company engaged an independent third party to assist with its goodwill impairment analysis. After performing Step 2 of its impairment analyses the Company determined that the implied value of its goodwill was significantly less than the carrying value resulting in a one-time, non-cash pretax impairment charge of $52,408,000 or 100% of its previous carrying value. The impairment charge was recorded in noninterest expense and did not negatively impact the Company’s or its subsidiary banks’ regulatory or tangible capital ratios.
 
 The implied fair value of goodwill under Step 2 of the impairment analysis is determined in the same manner as the amount of goodwill recognized in a business combination. Goodwill recognized in a business combination represents the excess of the fair value of a business acquired over the amounts assigned to all of the assets acquired (including intangible assets such as for core deposits and customer lists) and liabilities assumed. The fair value of assets and liabilities reflect assumptions as to market conditions at the date of impairment testing and significant judgment is applied. Changes to these assumptions could have a material impact on the determination of the implied fair value of goodwill at the date of impairment testing.
 
 In determining the fair value of its single reporting unit, the Company uses a combination of valuation methods including various market approaches using price multiples as well as an income approach utilizing a discounted cash flow analysis. The Company evaluates the results obtained under each valuation methodology to identify and understand the key components and to determine that the results are reasonable and appropriate under the circumstances.
 
 Under Step 1, the Company used four methods to determine the estimated fair value of its single reporting unit. The four different methods include an income approach and three market approaches. The income approach was based on discounted cash flows that required consideration of the cost of capital, residual value, and operating forecasts. An internal five-year forecast of the Company’s balance sheet and income statement activity was developed by considering key business drivers such as anticipated loan and deposit growth. The estimated cash flows over the five-year forecast period were discounted based on the Capital Asset Pricing Model (“CAPM”). The inputs used in the CAPM include a risk-free interest rate, market risk premium, beta value, and a Company-specific risk factor. The Company’s residual value at the end of the five-year discrete forecast period was calculated using the formula for a growing, perpetual annuity.
 
 For the market approach, the Company used three different methods: 1) the Guideline Public Company Method 2) the Mergers and Acquisitions Method and 3) the Company’s Stock Price Method. Under the Guideline Public Company Method, two groups of comparable peer companies were selected: Kentucky banks and regional banks. A book value multiple representing the lower quartile of the comparable companies was used in this analysis with a control premium of 24% added. The Mergers and Acquisitions Method consisted of examining transactions occurring between January 1, 2005 and November 30, 2009 involving commercial banks incorporated in Kentucky. Since there were no merger transactions meeting the criteria (commercial banks incorporated in Kentucky) between November 2008 and November 2009, the valuation under this approach used a price to book multiple representing data from the lower quartile of the transactions examined. The Company Stock Price Method estimates the Company’s market capitalization based on the closing stock price of the Company’s common stock on the valuation date. The number of outstanding common shares multiplied by the closing stock price on the valuation date plus an added control premium of 24% resulted in the total estimated market capitalization of the Company.
 
 The results of the income and market valuation approaches were weighted as follows to arrive at the final calculation of fair value: Guideline Public Company Method 60%; Company Stock Price Method 20%; and income approach (discounted cash flows) 20%. There was no weight given to the Mergers and Acquisitions Method because the most recent comparable transaction was approximately one year old and the mergers and actual acquisition multiples would likely be much lower due to the recent banking crisis. The final calculation of fair value by Step 1 indicated that the carrying value of the Company exceeded its fair value.
 
 115
 
 Since the carrying value of the Company exceeded its fair value, Step 2 of impairment testing was completed. To determine the implied fair value of goodwill, the fair value determined under Step 1 was allocated to all assets and liabilities of the single reporting unit including any recognized or unrecognized intangible assets. The allocation was done as if the Company was acquired in a business combination and the fair value of the Company was the price paid to acquire the Company. This allocation process is only performed for purposes of testing goodwill for impairment. The carrying values of recognized assets and liabilities (other than goodwill) were not adjusted nor were any new intangible assets recorded. Key valuations in Step 2 were the assessment of core deposit intangibles, the Commonwealth of Kentucky Relationship, the fair value of the loan portfolio, and the fair value of outstanding time deposits and long-term borrowings.
 
 Core deposits were valued using the Cost Savings Method, which is a form of the Income approach and Cost approach, using a 15% discount rate. The Company’s relationship with the Commonwealth of Kentucky was valued using an excess earnings method. The excess earnings method includes the determination of the earnings expected to be generated, estimated attrition rate, and risk associated with the future earnings stream among other assumptions. The Company concluded through this evaluation that its existing core deposit intangible asset was not impaired.
 
 The valuation of the loan portfolio included a discounted cash flow analysis. This analysis first included separating the portfolio into multiple tranches based on risk characteristics and repayment methods. The average time to maturity of the portfolio by tranche was determined and the respective estimated cash flows were discounted using current market interest rates.
 
 Time deposits were valued using a discounted cash flow analysis that considered the estimated remaining time to maturity, the most likely distribution of cash payments, and applying a current market interest rate to the cash flows based on the estimated maturity structure. Long-term borrowings were also valued using a discounted cash flow analysis. This analysis considered the estimated remaining time to maturity, interest rate risk, the amount and timing of estimated cash flows, current market rates, and the presence of any call or put features.
 
 The computations included in the impairment analysis require the Company to make significant estimates and assumptions. Critical assumptions that are used as part of these evaluations include developing cash flow projections and future earnings, selecting appropriate discount rates, systemic and nonsystemic risk factors, selecting relevant market comparables, incorporating general economic and market conditions, repayment assumptions, selecting an appropriate control premium, and projecting market growth.
 
 Acquired Intangible Assets
 
 Acquired core deposit and customer relationship intangible assets were as follows as of December 31 for the years indicated.
 2010


2009Amortized Intangible Assets(In thousands)

Gross

Carrying

Amount


Accumulated

Amortization


Gross

Carrying

Amount


Accumulated

AmortizationCore deposit intangibles

$
12,765


$
10,050


$
12,765


$
8,916Other customer relationship intangibles


3,689



2,852



3,689



2,549Total

$
16,454


$
12,902


$
16,454


$
11,465
 
 Aggregate amortization expense of core deposit and customer relationship intangible assets was $1,437,000, $1,952,000, and $2,602,000 for 2010, 2009, and 2008, respectively. Estimated amortization expense for each of the next five years is as follows:
 (In thousands)

Amount2011

$
1,1432012


1,0142013


5402014


4052015


450
 
 23.  Preferred Stock and Warrant
 
 On January 9, 2009, as part of the U.S. Department of Treasury’s (“Treasury”) Capital Purchase Program (“CPP”), the Company received a $30.0 million equity investment by issuing 30 thousand shares of Series A, no par value cumulative perpetual preferred stock to the Treasury pursuant to a Letter Agreement and Securities Purchase Agreement that was previously disclosed by the Company. The Company also issued a warrant to the Treasury allowing it to purchase 223,992 shares of the Company’s common stock at an exercise price of $20.09. The warrant can be exercised immediately and has a term of 10 years.
 
 116
 
 The non-voting Series A preferred shares issued, with a liquidation preference of $1 thousand per share, pay a cumulative cash dividend quarterly at 5% per annum during the first five years the preferred shares are outstanding, resetting to 9% thereafter if not redeemed. The ability of the Company to declare or pay dividends or distributions on, or purchase, redeem or otherwise acquire for consideration, shares of its common stock will be subject to restrictions, including a restriction against increasing dividends from the last quarterly cash dividend per share ($.33) declared on the common stock prior to October 14, 2008.  The redemption, purchase or other acquisition of trust preferred securities of the Company or its affiliates also will be restricted.  These restrictions will terminate on the earlier of (a) the third anniversary of the date of issuance of the preferred stock and (b) the date on which the preferred stock has been redeemed in whole or the Treasury has transferred all of the preferred stock to third parties, except that, after the third anniversary of the date of issuance of the preferred stock, if the preferred stock remains outstanding at such time, the Company may not increase its common dividends per share without obtaining consent of the Treasury. If the Company defers dividend payments on its Series A preferred shares for an aggregate of six quarterly dividend periods, the authorized number of directors of the Company will increase by two and the holders of the Series A preferred shares will have the right to elect directors to fill such director positions at the Company’s next annual meeting of stockholders or special meeting called for that purpose.
 
 The Company is also subject to certain of the executive compensation limitations included in the Emergency Economic Stabilization Act of 2008 (“EESA”). In this connection, as a condition to the closing of the preferred stock transaction, the Company’s senior executive officers (as defined in the Purchase Agreement) (the “Senior Executive Officers”), (i) voluntarily waived any claim against the Treasury or the Company for any changes to such officer’s compensation or benefits that are required to comply with the regulation issued by the Treasury under the CPP and acknowledged that the regulation may require modification of the compensation, bonus, incentive and other benefit plans, arrangements and policies and agreements as they relate to the period the Treasury owns the preferred stock of the Company; and (ii) entered into a letter agreement with the Company amending the benefit plans with respect to such Senior Executive Officers as may be necessary, during the period that the Treasury owns the preferred stock of the Company, as necessary to comply with Section 111(b) of EESA.
 
 The Company allocated the proceeds received from the Treasury, net of transaction costs, on a pro rata basis to the Series A preferred stock and the warrant based on their relative fair values. The Company used the Black-Scholes model to estimate the fair value of the warrant. The fair value of the Series A preferred stock was estimated using a discounted cash flow methodology and a discount rate of 13%. The Company assigned $2.0 million and $28.0 million to the warrant and the Series A preferred stock, respectively. The resulting discount on the Series A preferred stock is being accreted up to the $30.0 million liquidation amount over the five year expected life of the Series A preferred stock. The discount accretion is being recorded as additional preferred stock dividends, resulting in an effective dividend yield of 6.56%.
 
 24.  Subsequent Event
 
 The Internal Revenue Code grants preferential treatment to the interest income derived from debt issued by states and political subdivisions in that it is not subject to Federal taxation. As a financial institution, the Company is not allowed a tax deduction for a pro rata portion of the interest expense incurred to purchase debt with tax-free attributes. The amount of disallowed interest expense is determined by the total amount of debt issued during the calendar year by the issuer and dependent upon the issuer being considered a qualified small issuer. Debt purchased by a financial institution that meets the requirements to be designated a “qualified tax exempt obligation” has a lower interest expense disallowance than debt that does not meet the “qualified tax exempt obligation” designation. As part of the normal due diligence for a loan with tax-free attributes, the Company relies on the attestation of the borrower, legal counsel for the borrower, and the legal counsel for the Company concerning the representations of the borrower for their debt.  During the fourth quarter of 2010 the Company became aware that the qualified status of the debt issued by a customer was being reviewed by the Internal Revenue Service (“IRS”). The customer had previously made representations that their debt was qualified.
 
 During the first quarter of 2011 the Company became aware that this customer had received verbal notification of the IRS’s intent to issue an adverse ruling regarding the qualified status of the financing.  The Company has a potential accumulated tax liability of $402,000 at risk related to the determination for the tax years 2007 through 2010.   Under ASC 740, “Income Taxes”, the Company is required to recognize a tax position when it is more likely than not that the position would be sustained in a tax examination, with the tax examination being presumed to have occurred.  Additionally, ASC 740 indicates that a subsequent change in facts and circumstances should be recognized in the period in which the change occurs.   As such, the Company will record the accrual in the first quarter of 2011.
  The original loan contract contains provisions that the customer will indemnify the Company for any penalties, taxes or interest thereon for which the Company becomes liable as a result of a determination of taxability.  The Company intends to exercise its rights under the contract; however, due to the contingent nature of the indemnification provisions, the Company will not record the effects of the indemnification until it is realized.
 
 117
 
 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
 
 None.
 
 Item 9A. Controls and Procedures
 
 Evaluation of Disclosure Controls and Procedures
 As of the end of the period covered by this report, an evaluation was carried out under the supervision and with the participation of our management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures and internal control over financial reporting are, to the best of their knowledge, effective to ensure that information required to be disclosed by the Company in reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.
 
 The Company’s Chief Executive Officer and Chief Financial Officer have also concluded that there were no changes in the Company’s internal control over financial reporting or in other factors that occurred during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting or any corrective actions with regard to significant deficiencies and material weaknesses in internal control over financial reporting.
 
 Management’s Report on Internal Control Over Financial Reporting
 Management Responsibility.Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control system is designed to provide reasonable assurance to the Company’s management and Board of Directors regarding the reliability of financial reporting and the presentation of published financial statements. However, all internal control systems, no matter how well designed, have inherent limitations.
  General Description of Internal Control over Financial Reporting.Internal control over financial reporting refers to a process designed by, or under the supervision of, the Company’s Chief Executive Officer and Chief Financial Officer and effected by the Company’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
  ·
Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of Company assets;
 ·
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that Company’s receipts and expenditures are being made only in accordance with the authorization of Company’s management and members of the Company’s Board of Directors; and
 ·
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisitions, uses or dispositions of Company assets that could have a material effect on the Company’s financial statements.
 
 Inherent Limitations in Internal Control over Financial Reporting.Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations.  Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures.  Internal control over financial reporting also can be circumvented or overridden by collusion or other improper activities.  Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting.  However, these inherent limitations are known features of the financial reporting process, and it is possible to design into the process safeguards to reduce, though not eliminate, this risk.
 
 Management’s Assessment of the Company’s Internal Control over Financial Reporting.Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2010.  In making this assessment, the Company’s management used the criteria for effective internal control over financial reporting set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.
 
 As a result of our assessment of the Company’s internal control over financial reporting, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2010 to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms. This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting
  118
 
 firm pursuant to rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.
  Item9B.  Other Information
 
 None.
 
 PARTIII
 
 Item10. Directors, Executive Officers and Corporate Governance
 
 Positions and
Years of ServiceOffices With
With theExecutive Officer1
Age
the Registrant
RegistrantLloyd C. Hillard, Jr.
64
President and Chief
18*Executive Officer, Director2
 
 The Company has adopted a Code of Ethics that applies to the Company’s directors, officers and employees, including the Company’s chief executive officer and chief financial officer.  The Company makes available its Code of Ethics on its Internet website at www.farmerscapital.com.
 
 Additional information required by Item 10 is hereby incorporated by reference from the Company's definitive proxy statement in connection with its annual meeting of shareholders scheduled for May 10, 2011, which will be filed with the Commission on or about April 1, 2011, pursuant to Regulation 14A.
 *
Includes years of service with the Company and its subsidiaries.
 1
For Regulation O purposes, Frank W. Sower, Jr., Chairman of the Company’s board of directors, is considered an executive officer in name only.
 2
Also a director of Farmers Bank, United Bank (Chairman), First Citizens Bank, Citizens Northern, FCB Services, Farmers Insurance (Chairman), Leasing One (Chairman), FFKT Insurance, EG Properties, EKT Properties, and an administrative trustee of Farmers Capital Bank Trust I, Farmers Capital Bank Trust II, and Farmers Capital Bank Trust III.
 
 Item11. Executive Compensation
 
 Item12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
 
 Item13. Certain Relationships and Related Transactions
 
 Item14.  Principal Accounting Fees and Services
 
 The information required by Items 11 through 14 is hereby incorporated by reference from the Company's definitive proxy statement in connection with its annual meeting of shareholders scheduled for May 10, 2011, which will be filed with the Commission on or about April 1, 2011, pursuant to Regulation 14A.
 
 119
 
 PARTIV
 
 Item15. Exhibits, Financial Statement Schedules
 
 (a)1.
Financial Statements
 
 The following consolidated financial statements and report of independent registered accounting firm of the Company is included in Part II, Item 8 on pages 75 through 117:
 
 Report of Independent Registered Public Accounting Firm
 Consolidated Balance Sheets
 Consolidated Statements of Operations
 Consolidated Statements of Comprehensive (Loss) Income
 Consolidated Statements of Changes in Shareholders’ Equity
 Consolidated Statements of Cash Flows
 Notes to Consolidated Financial Statements
 
 (a)2.
Financial Statement Schedules
 
 All schedules are omitted for the reason they are not required, or are not applicable, or the required information is disclosed elsewhere in the financial statements and related notes thereto.
 
 (a)3.
Exhibits:
 
 3.1
Articles of Incorporation of Farmers Capital Bank Corporation (incorporated by reference to Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2006, the Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2003, and Current Report on Form 8-K dated January 13, 2009).3.2
Amended and Restated Bylaws of Farmers Capital Bank Corporation (incorporated by reference to Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2009).4.1*
Junior Subordinated Indenture, dated as of July 21, 2005, between Farmers Capital Bank Corporation and Wilmington Trust Company, as Trustee, relating to unsecured junior subordinated deferrable interest notes that mature in 2035.4.2*
Amended and Restated Trust Agreement, dated as of July 21, 2005, among Farmers Capital Bank Corporation, as Depositor, Wilmington Trust Company, as Property and Delaware Trustee, the Administrative Trustees (as named therein), and the Holders (as defined therein).4.3*
Guarantee Agreement, dated as of July 21, 2005, between Farmers Capital Bank Corporation, as Guarantor, and Wilmington Trust Company, as Guarantee Trustee.4.4*
Junior Subordinated Indenture, dated as of July 26, 2005, between Farmers Capital Bank Corporation and Wilmington Trust Company, as Trustee, relating to unsecured junior subordinated deferrable interest notes that mature in 2035.4.5*
Amended and Restated Trust Agreement, dated as of July 26, 2005, among Farmers Capital Bank Corporation, as Depositor, Wilmington Trust Company, as Property and Delaware Trustee, the Administrative Trustees (as named therein), and the Holders (as defined therein).4.6*
Guarantee Agreement, dated as of July 26, 2005, between Farmers Capital Bank Corporation, as Guarantor, and Wilmington Trust Company, as Guarantee Trustee.4.7*
Indenture, dated as of August 14, 2007 between Farmers Capital Bank Corporation, as Issuer, and Wilmington Trust Company, as Trustee, relating to fixed/floating rate junior subordinated debt due 2037.4.8*
Amended and Restated Declaration of Trust, dated as of August 14, 2007, by Farmers Capital Bank Corporation, as Sponsor, Wilmington Trust Company, as Delaware and Institutional Trustee, the Administrative Trustees (as named therein), and the Holders (as defined therein).  120
  4.9*
Guarantee Agreement, dated as of August 14, 2007, between Farmers Capital Bank Corporation, as Guarantor, and Wilmington Trust Company, as Guarantee Trustee.4.10
Form of Certificate for Fixed Rate Cumulative Perpetual Preferred Stock, Series A

(incorporated by reference to the Current Report on Form 8-K dated January 13, 2009).4.11
Warrant for Purchase of Shares of Common Stock

(incorporated by reference to the Current Report on Form 8-K dated January 13, 2009).10.1
Agreement and Plan of Merger, Dated July 1, 2005, as Amended, by and among Citizens Bancorp, Inc., Citizens Acquisition Subsidiary Corp, and Farmers Capital Bank Corporation

(incorporated by reference to Appendix A of Registration Statement filed on Form S-4 on October 11, 2005).10.2
Amended and Restated Plan of Merger of Citizens National Bancshares, Inc. with and into FCBC Acquisition Subsidiary, LLC (incorporated by reference to Appendix A of Proxy Statement for Special Meeting of Shareholders of Citizens National Bancshares, Inc. and Prospectus in connection with an offer of up to 600,000 shares of its common stock of Farmers Capital Bank Corporation filed on Form 424B3 on August 7, 2006).10.3
Stock Purchase Agreement Dated June 1, 2006 by and among Farmers Capital Bank Corporation, Kentucky Banking Centers, Inc. and Citizens First Corporation. (incorporated by reference to the Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2008).21
Subsidiaries of the Registrant23
Consent of Independent Registered Public Accounting Firm31.1
CEO Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 200231.2
CFO Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 200232
Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 200299.1
Annual Certification of Chief Executive Officer Pursuant to 31 C.F.R. 30.1599.2
Annual Certification of Chief Financial Officer Pursuant to 31 C.F.R. 30.15
  *
Exhibit not included pursuant to Item 601(b)(4)(iii) and (v) of Regulation S-K. The Company will provide a copy of such exhibit to the Securities and Exchange Commission upon request.
 
 121
 
 SIGNATURES
 
 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 FARMERS CAPITAL BANK CORPORATIONBy:
/s/ Lloyd C. Hillard, Jr.Lloyd C. Hillard, Jr.President and Chief Executive OfficerDate:
March 8, 2011
 
 
 
 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
 
 
 /s/ Lloyd C. Hillard, Jr.
President, Chief Executive Officer
March 8, 2011Lloyd C. Hillard, Jr.
and Director (principal executiveofficer of the Registrant)/s/ Frank W. Sower, Jr.
Chairman
February 26, 2011Frank W. Sower, Jr./s/ Ben F. Brown
Director
February 28, 2011Ben F. Brown/s/ Daniel M. Sullivan
Director
March 1, 2011Daniel M. Sullivan/s/ R. Terry Bennett
Director
February 26, 2011R. Terry Bennett/s/ Shelley S. Sweeney
Director
February 27, 2011Shelley S. Sweeney/s/ David R. O’Bryan
Director
February 28, 2011David R. O’Bryan/s/ William C. Nash
Director
February 26, 2011Dr. William C. Nash/s/ J. D. Sutterlin
Director
February 25, 2011Dr. John D. Sutterlin/s/ Marvin E. Strong, Jr.
Director
February 28, 2011Marvin E. Strong, Jr./s/ J. Barry Banker
Director
February 28, 2011J. Barry Banker/s/ Michael J. Crawford
Director
February 28, 2011Michael J. Crawford/s/ Doug Carpenter
Executive Vice President, Secretary
March 8, 2011C. Douglas Carpenter
and Chief Financial Officer(principal financial and accounting officer)
 
 122
 
 INDEXOF EXHIBITS
 
 
 
 Exhibit

Page21
Subsidiaries of the Registrant
12423
Consent of Independent Registered Public Accounting Firm
12531.1
CEO Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
12631.2
CFO Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
12732
Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
12899.1
Annual Certification of Chief Executive Officer Pursuant to 31 C.F.R. 30.15
12999.2
Annual Certification of Chief Financial Officer Pursuant to 31 C.F.R. 30.15
131
  123