UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

_______________________________



FORM 10-Q









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



For the Quarterly Period Ended June 30, 2012



OR





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



For the transition period from ________ to ________



Commission file number 0-22345



SHORE BANCSHARES, INC.

(Exact name of registrant as specified in
its charter)



| | Maryland                        |  | 52-1974638          | 
| | ------------------------------- |  | ------------------- | 
| | (State or Other Jurisdiction of |  | (I.R.S. Employer    | 
| | Incorporation or Organization)  |  | Identification No.) | 



| | 18 East Dover Street, Easton, Maryland   |  | 21601      | 
| | ---------------------------------------- |  | ---------- | 
| | (Address of Principal Executive Offices) |  | (Zip Code) | 



(410) 763-7800

Registrant’s Telephone Number, Including
Area Code





|                                                                                  | N/A | 
|--------------------------------------------------------------------------------- | --- | 
|Former name, former address and former fiscal year, if changed since last report.



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 periods that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days. Yes xNo£



Indicate by check mark whether the registrant has submitted
electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant
to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files). Yes x No £



Indicate by check mark
whether the registrant is a large accelerated filer, an accelerated filer, 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. (Check one):





| | Large accelerated filer                       |  ̈ | Accelerated filer         | x
| | --------------------------------------------- | - | ------------------------- | -
| | Non-accelerated filer                         |  ̈ | Smaller reporting company |  ̈
| | (Do not check if a smaller reporting company) |   |                          



Indicate by check mark
whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes £No x



APPLICABLE ONLY TO CORPORATE ISSUERS



Indicate the number of shares outstanding
of each of the issuer’s classes of common stock, as of the latest practicable date: 8,457,359 shares of common stock outstanding
as of July 31, 2012.















INDEX



|                                                                                              | Page
|--------------------------------------------------------------------------------------------- | ----
|                                                                                              |     
|Part I. Financial Information                                                                 | 2   
|                                                                                              |     
|Item 1. Financial Statements                                                                  | 2   
|                                                                                              |     
|Consolidated Balance Sheets -                                                                 |     
|June 30, 2012 (unaudited) and December 31, 2011                                               | 2   
|                                                                                              |     
|Consolidated Statements of Operations -                                                       |     
|For the three and six months ended June 30, 2012 and 2011 (unaudited)                         | 3   
|                                                                                              |     
|Consolidated Statements of Comprehensive Income (Loss) -                                      |     
|For the three and six months ended June 30, 2012 and 2011 (unaudited)                         | 4   
|                                                                                              |     
|Consolidated Statements of Changes in Stockholders’ Equity -                                  |     
|For the six months ended June 30, 2012 and 2011 (unaudited)                                   | 5   
|                                                                                              |     
|Consolidated Statements of Cash Flows -                                                       |     
|For the six months ended June 30, 2012 and 2011 (unaudited)                                   | 6   
|                                                                                              |     
|Notes to Consolidated Financial Statements (unaudited)                                        | 7   
|                                                                                              |     
|Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations | 27  
|                                                                                              |     
|Item 3. Quantitative and Qualitative Disclosures about Market Risk                            | 37  
|                                                                                              |     
|Item 4. Controls and Procedures                                                               | 37  
|                                                                                              |     
|Part II. Other Information                                                                    | 38  
|                                                                                              |     
|Item 1A. Risk Factors                                                                         | 38  
|                                                                                              |     
|Item 6. Exhibits                                                                              | 38  
|                                                                                              |     
|Signatures                                                                                    | 38  
|                                                                                              |     
|Exhibit Index                                                                                 | 39  







1









PART I – FINANCIAL INFORMATION

Item
1. Financial Statements.

SHORE BANCSHARES, INC.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share
amounts)



|                                                                                                                                  |  | June 30, |             |   | December 31, |  
|--------------------------------------------------------------------------------------------------------------------------------- |  | -------- | ----------- | - | ------------ | -
|                                                                                                                                  |  | 2012     |             |   | 2011         |  
|ASSETS                                                                                                                            |  |          | (Unaudited) |   |              |  
|Cash and due from banks                                                                                                           |  | $        | 23,037      |   |              | $
|Interest-bearing deposits with other banks                                                                                        |  |          | 137,267     |   |              |  
|Federal funds sold                                                                                                                |  |          | 9,269       |   |              |  
|Investment securities:                                                                                                            |  |          |             |   |              |  
|Available for sale, at fair value                                                                                                 |  |          | 133,244     |   |              |  
|Held to maturity, at amortized cost – fair value of $5,425 (2012) and $6,732 (2011)                                               |  |          | 5,168       |   |              |  
|                                                                                                                                  |  |          |             |   |              |  
|Loans                                                                                                                             |  |          | 809,958     |   |              |  
|Less:  allowance for credit losses                                                                                                |  |          | (12,990     | ) |              |  
|Loans, net                                                                                                                        |  |          | 796,968     |   |              |  
|                                                                                                                                  |  |          |             |   |              |  
|Premises and equipment, net                                                                                                       |  |          | 15,398      |   |              |  
|Goodwill                                                                                                                          |  |          | 12,454      |   |              |  
|Other intangible assets, net                                                                                                      |  |          | 3,986       |   |              |  
|Other real estate and other assets owned, net                                                                                     |  |          | 11,499      |   |              |  
|Other assets                                                                                                                      |  |          | 27,043      |   |              |  
|TOTAL ASSETS                                                                                                                      |  | $        | 1,175,333   |   |              | $
|                                                                                                                                  |  |          |             |   |              |  
|LIABILITIES                                                                                                                       |  |          |             |   |              |  
|Deposits:                                                                                                                         |  |          |             |   |              |  
|Noninterest-bearing                                                                                                               |  | $        | 149,472     |   |              | $
|Interest-bearing                                                                                                                  |  |          | 883,231     |   |              |  
|Total deposits                                                                                                                    |  |          | 1,032,703   |   |              |  
|                                                                                                                                  |  |          |             |   |              |  
|Short-term borrowings                                                                                                             |  |          | 13,826      |   |              |  
|Other liabilities                                                                                                                 |  |          | 8,882       |   |              |  
|Long-term debt                                                                                                                    |  |          | 455         |   |              |  
|TOTAL LIABILITIES                                                                                                                 |  |          | 1,055,866   |   |              |  
|                                                                                                                                  |  |          |             |   |              |  
|STOCKHOLDERS’ EQUITY                                                                                                              |  |          |             |   |              |  
|Common stock, par value $.01 per share; shares authorized – 35,000,000; shares issued and outstanding – 8,457,359 (2012 and 2011) |  |          | 85          |   |              |  
|Additional paid in capital                                                                                                        |  |          | 32,087      |   |              |  
|Retained earnings                                                                                                                 |  |          | 87,973      |   |              |  
|Accumulated other comprehensive loss                                                                                              |  |          | (678        | ) |              |  
|TOTAL STOCKHOLDERS’ EQUITY                                                                                                        |  |          | 119,467     |   |              |  
|TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                        |  | $        | 1,175,333   |   |              | $



See accompanying notes
to Consolidated Financial Statements.



2











SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

(Dollars in thousands, except per share
amounts)



|                                                      |  | For the Three Months Ended |        |  | For the Six Months Ended |  
|----------------------------------------------------- |  | -------------------------- | ------ |  | ------------------------ | -
|                                                      |  | June 30,                   |        |  | June 30,                 |  
|                                                      |  | 2012                       |        |  | 2011                     |  
|                                                      |  |                            |        |  |                          |  
|INTEREST INCOME                                       |  |                            |        |  |                          |  
|Interest and fees on loans                            |  | $                          | 10,890 |  |                          | $
|Interest and dividends on investment securities:      |  |                            |        |  |                          |  
|Taxable                                               |  |                            | 707    |  |                          |  
|Tax-exempt                                            |  |                            | 32     |  |                          |  
|Interest on federal funds sold                        |  |                            | 2      |  |                          |  
|Interest on deposits with other banks                 |  |                            | 61     |  |                          |  
|Total interest income                                 |  |                            | 11,692 |  |                          |  
|                                                      |  |                            |        |  |                          |  
|INTEREST EXPENSE                                      |  |                            |        |  |                          |  
|Interest on deposits                                  |  |                            | 2,643  |  |                          |  
|Interest on short-term borrowings                     |  |                            | 11     |  |                          |  
|Interest on long-term debt                            |  |                            | 5      |  |                          |  
|Total interest expense                                |  |                            | 2,659  |  |                          |  
|                                                      |  |                            |        |  |                          |  
|NET INTEREST INCOME                                   |  |                            | 9,033  |  |                          |  
|Provision for credit losses                           |  |                            | 3,525  |  |                          |  
|                                                      |  |                            |        |  |                          |  
|NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES |  |                            | 5,508  |  |                          |  
|                                                      |  |                            |        |  |                          |  
|NONINTEREST INCOME                                    |  |                            |        |  |                          |  
|Service charges on deposit accounts                   |  |                            | 622    |  |                          |  
|Trust and investment fee income                       |  |                            | 446    |  |                          |  
|Gains on sales of investment securities               |  |                            | -      |  |                          |  
|Insurance agency commissions                          |  |                            | 2,406  |  |                          |  
|Other noninterest income                              |  |                            | 1,103  |  |                          |  
|Total noninterest income                              |  |                            | 4,577  |  |                          |  
|                                                      |  |                            |        |  |                          |  
|NONINTEREST EXPENSE                                   |  |                            |        |  |                          |  
|Salaries and wages                                    |  |                            | 4,376  |  |                          |  
|Employee benefits                                     |  |                            | 956    |  |                          |  
|Occupancy expense                                     |  |                            | 638    |  |                          |  
|Furniture and equipment expense                       |  |                            | 212    |  |                          |  
|Data processing                                       |  |                            | 694    |  |                          |  
|Directors’ fees                                       |  |                            | 127    |  |                          |  
|Amortization of other intangible assets               |  |                            | 96     |  |                          |  
|Insurance agency commissions expense                  |  |                            | 344    |  |                          |  
|FDIC insurance premium expense                        |  |                            | 344    |  |                          |  
|Other noninterest expenses                            |  |                            | 1,876  |  |                          |  
|Total noninterest expense                             |  |                            | 9,663  |  |                          |  
|                                                      |  |                            |        |  |                          |  
|INCOME (LOSS) BEFORE INCOME TAXES                     |  |                            | 422    |  |                          |  
|Income tax expense (benefit)                          |  |                            | 129    |  |                          |  
|                                                      |  |                            |        |  |                          |  
|NET INCOME (LOSS)                                     |  | $                          | 293    |  |                          | $
|                                                      |  |                            |        |  |                          |  
|Basic net income (loss) per common share              |  | $                          | 0.03   |  |                          | $
|Diluted net income (loss) per common share            |  | $                          | 0.03   |  |                          | $
|Dividends paid per common share                       |  | $                          | -      |  |                          | $



|See accompanying notes to Consolidated Financial Statements. |  |  | 
|------------------------------------------------------------ |  |  | 





3







SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE
INCOME (LOSS) (Unaudited)

(Dollars in thousands)



|                                                                  |  | For the Three Months Ended 
June 30, |      |   | For the Six Months Ended 
June 30, |  
|----------------------------------------------------------------- |  | ------------------------------------ | ---- | - | ---------------------------------- | -
|                                                                  |  | 2012                                 |      |   | 2011                               |  
|                                                                  |  |                                      |      |   |                                    |  
|Net income (loss)                                                 |  | $                                    | 293  |   |                                    | $
|                                                                  |  |                                      |      |   |                                    |  
|Other comprehensive income                                        |  |                                      |      |   |                                    |  
|Securities available for sale:                                    |  |                                      |      |   |                                    |  
|Unrealized holding gains on available-for-sale securities         |  |                                      | 534  |   |                                    |  
|Tax effect                                                        |  |                                      | (216 | ) |                                    |  
|Reclassification of gains recognized in net income                |  |                                      | -    |   |                                    |  
|Tax effect                                                        |  |                                      | -    |   |                                    |  
|Net of tax amount                                                 |  |                                      | 318  |   |                                    |  
|                                                                  |  |                                      |      |   |                                    |  
|Cash flow hedging activities:                                     |  |                                      |      |   |                                    |  
|Unrealized holding gains (losses) on cash flow hedging activities |  |                                      | 421  |   |                                    |  
|Tax effect                                                        |  |                                      | (170 | ) |                                    |  
|Net of tax amount                                                 |  |                                      | 251  |   |                                    |  
|Total other comprehensive income                                  |  |                                      | 569  |   |                                    |  
|Comprehensive income (loss)                                       |  | $                                    | 862  |   |                                    | $



See accompanying notes to Consolidated Financial Statements.





4







SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS
OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)

For the Six Months Ended June 30, 2012 and
2011

(Dollars in thousands, except per share
amounts)



|                                                                |  |        |    |  |         |   |       |            |  |   |          |   |  | Accumulated   |        |   |               |  
|--------------------------------------------------------------- |  | ------ | -- |  | ------- | - | ----- | ---------- |  | - | -------- | - |  | ------------- | ------ | - | ------------- | -
|                                                                |  |        |    |  |         |   |       | Additional |  |   |          |   |  | Other         |        |   | Total         |  
|                                                                |  | Common |    |  |         |   |       | Paid in    |  |   | Retained |   |  | Comprehensive |        |   | Stockholders’ |  
|                                                                |  | Stock  |    |  | Warrant |   |       | Capital    |  |   | Earnings |   |  | Income (Loss) |        |   | Equity        |  
|Balances, January 1, 2012                                       |  | $      | 85 |  |         | $ | -     |            |  | $ | 32,052   |   |  | $             | 90,801 |   |               | $
|                                                                |  |        |    |  |         |   |       |            |  |   |          |   |  |               |        |   |               |  
|Comprehensive loss:                                             |  |        |    |  |         |   |       |            |  |   |          |   |  |               |        |   |               |  
|Net loss                                                        |  |        | -  |  |         |   | -     |            |  |   | -        |   |  |               | (2,743 | ) |               |  
|Unrealized gains on available-for-sale securities, net of taxes |  |        | -  |  |         |   | -     |            |  |   | -        |   |  |               | -      |   |               |  
|Unrealized gains on cash flow hedging activities, net of taxes  |  |        | -  |  |         |   | -     |            |  |   | -        |   |  |               | -      |   |               |  
|Total comprehensive loss                                        |  |        |    |  |         |   |       |            |  |   |          |   |  |               |        |   |               |  
|                                                                |  |        |    |  |         |   |       |            |  |   |          |   |  |               |        |   |               |  
|Stock-based compensation                                        |  |        | -  |  |         |   | -     |            |  |   | 35       |   |  |               | -      |   |               |  
|                                                                |  |        |    |  |         |   |       |            |  |   |          |   |  |               |        |   |               |  
|Cash dividends paid ($0.01 per share)                           |  |        | -  |  |         |   | -     |            |  |   | -        |   |  |               | (85    | ) |               |  
|                                                                |  |        |    |  |         |   |       |            |  |   |          |   |  |               |        |   |               |  
|Balances, June 30, 2012                                         |  | $      | 85 |  |         | $ | -     |            |  | $ | 32,087   |   |  | $             | 87,973 |   |               | $
|                                                                |  |        |    |  |         |   |       |            |  |   |          |   |  |               |        |   |               |  
|Balances, January 1, 2011                                       |  | $      | 84 |  |         | $ | 1,543 |            |  | $ | 30,242   |   |  | $             | 92,458 |   |               | $
|                                                                |  |        |    |  |         |   |       |            |  |   |          |   |  |               |        |   |               |  
|Comprehensive loss:                                             |  |        |    |  |         |   |       |            |  |   |          |   |  |               |        |   |               |  
|Net loss                                                        |  |        | -  |  |         |   | -     |            |  |   | -        |   |  |               | (1,316 | ) |               |  
|Unrealized gains on available-for-sale securities, net of taxes |  |        | -  |  |         |   | -     |            |  |   | -        |   |  |               | -      |   |               |  
|Unrealized losses on cash flow hedging activities, net of taxes |  |        | -  |  |         |   | -     |            |  |   | -        |   |  |               | -      |   |               |  
|Total comprehensive loss                                        |  |        |    |  |         |   |       |            |  |   |          |   |  |               |        |   |               |  
|                                                                |  |        |    |  |         |   |       |            |  |   |          |   |  |               |        |   |               |  
|Shares issued for employee stock-based awards                   |  |        | 1  |  |         |   | -     |            |  |   | (1       | ) |  |               | -      |   |               |  
|                                                                |  |        |    |  |         |   |       |            |  |   |          |   |  |               |        |   |               |  
|Stock-based compensation                                        |  |        | -  |  |         |   | -     |            |  |   | 93       |   |  |               | -      |   |               |  
|                                                                |  |        |    |  |         |   |       |            |  |   |          |   |  |               |        |   |               |  
|Cash dividends paid ($0.07 per share)                           |  |        | -  |  |         |   | -     |            |  |   | -        |   |  |               | (591   | ) |               |  
|                                                                |  |        |    |  |         |   |       |            |  |   |          |   |  |               |        |   |               |  
|Balances, June 30, 2011                                         |  | $      | 85 |  |         | $ | 1,543 |            |  | $ | 30,334   |   |  | $             | 90,551 |   |               | $



See accompanying notes to Consolidated Financial Statements.





5







SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(Dollars in thousands)



|                                                                                            |  | For the Six Months Ended |        
|------------------------------------------------------------------------------------------- |  | ------------------------ | -------
|                                                                                            |  | June 30,                 |        
|                                                                                            |  | 2012                     |        
|CASH FLOWS FROM OPERATING ACTIVITIES:                                                       |  |                          |        
|Net loss                                                                                    |  | $                        | (2,743 
|Adjustments to reconcile net loss to net cash provided by operating activities:             |  |                          |        
|Provision for credit losses                                                                 |  |                          | 11,895 
|Depreciation and amortization                                                               |  |                          | 1,324  
|Discount accretion on debt securities                                                       |  |                          | (39    
|Stock-based compensation expense                                                            |  |                          | 141    
|Excess tax expense from stock-based arrangements                                            |  |                          | (106   
|Deferred income tax expense (benefit)                                                       |  |                          | 238    
|Gains on sales of investment securities                                                     |  |                          | -      
|Gains on disposals of premises and equipment                                                |  |                          | (226   
|Losses on sales of other real estate owned                                                  |  |                          | 862    
|Net changes in:                                                                             |  |                          |        
|Accrued interest receivable                                                                 |  |                          | 289    
|Other assets                                                                                |  |                          | (972   
|Accrued interest payable                                                                    |  |                          | 19     
|Other liabilities                                                                           |  |                          | 110    
|Net cash provided by operating activities                                                   |  |                          | 10,792 
|                                                                                            |  |                          |        
|CASH FLOWS FROM INVESTING ACTIVITIES:                                                       |  |                          |        
|Proceeds from maturities and principal payments of investment securities available for sale |  |                          | 21,308 
|Proceeds from sales of investment securities available for sale                             |  |                          | -      
|Purchases of investment securities available for sale                                       |  |                          | (24,238
|Proceeds from maturities and principal payments of investment securities held to maturity   |  |                          | 1,305  
|Net change in loans                                                                         |  |                          | 13,529 
|Purchases of premises and equipment                                                         |  |                          | (1,381 
|Proceeds from sales of premises and equipment                                               |  |                          | 307    
|Proceeds from sales of other real estate owned                                              |  |                          | 1,395  
|Net cash provided by (used in) investing activities                                         |  |                          | 12,225 
|                                                                                            |  |                          |        
|CASH FLOWS FROM FINANCING ACTIVITIES:                                                       |  |                          |        
|Net change in noninterest-bearing deposits                                                  |  |                          | 15,671 
|Net change in interest-bearing deposits                                                     |  |                          | 7,113  
|Net change in short-term borrowings                                                         |  |                          | (3,991 
|Excess tax expense from stock-based arrangements                                            |  |                          | 106    
|Common stock dividends paid                                                                 |  |                          | (85    
|Net cash provided by (used in) financing activities                                         |  |                          | 18,814 
|Net increase in cash and cash equivalents                                                   |  |                          | 41,831 
|Cash and cash equivalents at beginning of period                                            |  |                          | 127,742
|Cash and cash equivalents at end of period                                                  |  | $                        | 169,573
|                                                                                            |  |                          |        
|Supplemental cash flows information:                                                        |  |                          |        
|Interest paid                                                                               |  | $                        | 5,302  
|Income taxes paid                                                                           |  | $                        | 109    
|Transfers from loans to other real estate owned                                             |  | $                        | 4,371  





See accompanying notes to Consolidated Financial Statements.





6







Shore Bancshares, Inc.

Notes to Consolidated Financial Statements

For the Three and Six Months Ended June
30, 2012 and 2011

(Unaudited)



Note 1 - Basis of Presentation



The
consolidated financial statements include the accounts of Shore Bancshares, Inc. and its subsidiaries with all significant intercompany
transactions eliminated. 	The consolidated financial statements conform to accounting principles generally accepted in the United
States of America (“GAAP”) and to prevailing practices within the banking industry. The accompanying interim financial
statements are unaudited; however, in the opinion of management all adjustments necessary to present fairly the consolidated financial
position at June 30, 2012, the consolidated results of operations and comprehensive income (loss) for the three and six months
ended June 30, 2012 and 2011, and changes in stockholders’ equity and cash flows for the six months ended June 30, 2012 and
2011, have been included. All such adjustments are of a normal recurring nature. The amounts as of December 31, 2011 were derived
from the 2011 audited financial statements. The results of operations for the three and six months ended June 30, 2012 are not
necessarily indicative of the results to be expected for any other interim period or for the full year. This Quarterly Report on
Form 10-Q should be read in conjunction with the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December
31, 2011. For purposes of comparability, certain reclassifications have been made to amounts previously reported to conform with
the current period presentation.



When used in these notes, the term “the
Company” refers to Shore Bancshares, Inc. and, unless the context requires otherwise, its consolidated subsidiaries.



Recent Accounting Pronouncements



Accounting Standards Update (“ASU”)
2011-03, “Reconsideration of Effective Control for Repurchase Agreements.” ASU 2011-03 affects all entities
that enter into agreements to transfer financial assets that both entitle and obligate the transferor to repurchase or redeem the
financial assets before their maturity. The amendments in ASU 2011-03 remove from the assessment of effective control the criterion
relating to the transferor’s ability to repurchase or redeem financial assets on substantially the agreed terms, even in
the event of default by the transferee. ASU 2011-03 also eliminates the requirement to demonstrate that the transferor possesses
adequate collateral to fund substantially all the cost of purchasing replacement financial assets. ASU 2011-03 became effective
for the Company on January 1, 2012 and did not have a significant impact on the Company’s financial statements.



ASU 2011-04, "Fair Value Measurement
- Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRSs." ASU 2011-04
amends Topic 820, "Fair Value Measurements and Disclosures," to converge the fair value measurement guidance in
U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards. ASU 2011-04 clarifies the application
of existing fair value measurement requirements, changes certain principles in Topic 820 and requires additional fair value
disclosures. ASU 2011-04 became effective for the Company on January 1, 2012 and, aside from new disclosures included
in Note 8 – Fair Value Measurements, did not have a significant impact on the Company’s financial statements.



ASU 2011-08, "Intangibles - Goodwill
and Other - Testing Goodwill for Impairment." ASU 2011-08 amends Topic 350, "Intangibles – Goodwill
and Other," to give entities the option to first assess qualitative factors to determine whether the existence of events or
circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its
carrying amount. If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not
that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary.
However, if an entity concludes otherwise, then it is required to perform the first step of the two-step impairment test by calculating
the fair value of the reporting unit and comparing the fair value with the carrying amount of the reporting unit. ASU 2011-08
became effective for the Company on January 1, 2012 and did not have a significant impact on the Company's financial statements.





7











Note 2 – Earnings/(Loss)
Per Share



Basic earnings/(loss) per common share
is calculated by dividing net income/(loss) available to common stockholders by the weighted average number of common shares outstanding
during the period. Diluted earnings/(loss) per common share is calculated by dividing net income/(loss) available to common stockholders
by the weighted average number of common shares outstanding during the period, adjusted for the dilutive effect of common stock
equivalents (stock-based awards and the warrant). There is no dilutive effect on the loss per share during loss periods. The following
table provides information relating to the calculation of earnings/(loss) per common share:



|                                              |  | For the Three Months Ended |       |  | For the Six Months Ended |  
|--------------------------------------------- |  | -------------------------- | ----- |  | ------------------------ | -
|                                              |  | June 30,                   |       |  | June 30,                 |  
|(In thousands, except per share data)         |  | 2012                       |       |  | 2011                     |  
|Net income (loss)                             |  | $                          | 293   |  |                          | $
|Weighted average shares outstanding - Basic   |  |                            | 8,457 |  |                          |  
|Dilutive effect of common stock equivalents   |  |                            | -     |  |                          |  
|Weighted average shares outstanding - Diluted |  |                            | 8,457 |  |                          |  
|Earnings (loss) per common share - Basic      |  | $                          | 0.03  |  |                          | $
|Earnings (loss) per common share - Diluted    |  | $                          | 0.03  |  |                          | $



The calculations of diluted earnings/(loss)
per share for the three and six months ended June 30, 2012 excluded 57 thousand and 37 thousand weighted average common stock equivalents,
respectively, because the effect of including them would have been antidilutive. The calculations of diluted earnings/(loss) per
share for the three and six months ended June 30, 2011 each excluded 180 thousand weighted average common stock equivalents because
the effect of including them would have been antidilutive.





8









Note 3 – Investment
Securities



The following table provides information on the amortized cost
and estimated fair values of investment securities.



|                                                         |  |           |         |  | Gross      |   |       | Gross      |  |   | Estimated | 
|-------------------------------------------------------- |  | --------- | ------- |  | ---------- | - | ----- | ---------- |  | - | --------- | 
|                                                         |  | Amortized |         |  | Unrealized |   |       | Unrealized |  |   | Fair      | 
|(Dollars in thousands)                                   |  | Cost      |         |  | Gains      |   |       | Losses     |  |   | Value     | 
|Available-for-sale securities:                           |  |           |         |  |            |   |       |            |  |   |           | 
|June 30, 2012:                                           |  |           |         |  |            |   |       |            |  |   |           | 
|Obligations of U.S. Government agencies and corporations |  | $         | 34,300  |  |            | $ | 914   |            |  | $ | 1         | 
|Mortgage-backed securities                               |  |           | 95,146  |  |            |   | 2,303 |            |  |   | 35        | 
|Equity securities                                        |  |           | 585     |  |            |   | 32    |            |  |   | -         | 
|Total                                                    |  | $         | 130,031 |  |            | $ | 3,249 |            |  | $ | 36        | 
|                                                         |  |           |         |  |            |   |       |            |  |   |           | 
|                                                         |  |           |         |  |            |   |       |            |  |   |           | 
|December 31, 2011:                                       |  |           |         |  |            |   |       |            |  |   |           | 
|Obligations of U.S. Government agencies and corporations |  | $         | 41,360  |  |            | $ | 803   |            |  | $ | 15        | 
|Mortgage-backed securities                               |  |           | 85,545  |  |            |   | 1,587 |            |  |   | 99        | 
|Equity securities                                        |  |           | 577     |  |            |   | 22    |            |  |   | -         | 
|Total                                                    |  | $         | 127,482 |  |            | $ | 2,412 |            |  | $ | 114       | 
|                                                         |  |           |         |  |            |   |       |            |  |   |           | 
|                                                         |  |           |         |  |            |   |       |            |  |   |           | 
|Held-to-maturity securities:                             |  |           |         |  |            |   |       |            |  |   |           | 
|June 30, 2012:                                           |  |           |         |  |            |   |       |            |  |   |           | 
|Obligations of states and political subdivisions         |  | $         | 5,168   |  |            | $ | 257   |            |  | $ | -         | 
|                                                         |  |           |         |  |            |   |       |            |  |   |           | 
|December 31, 2011:                                       |  |           |         |  |            |   |       |            |  |   |           | 
|Obligations of states and political subdivisions         |  | $         | 6,480   |  |            | $ | 252   |            |  | $ | -         | 



The following table provides information
about gross unrealized losses and fair value by length of time that the individual available-for-sale securities have been in a
continuous unrealized loss position at June 30, 2012.



|                                      |  | Less than 12 Months |        |  | More than 12 Months |   |    | Total       | 
|------------------------------------- |  | ------------------- | ------ |  | ------------------- | - | -- | ----------- | 
|(Dollars in thousands)                |  | Fair  Value         |        |  | Unrealized Losses   |   |    | Fair  Value | 
|Available-for-sale securities:        |  |                     |        |  |                     |   |    |             | 
|U.S. Gov’t. agencies and corporations |  | $                   | 3,999  |  |                     | $ | 1  |             | 
|Mortgage-backed securities            |  |                     | 13,421 |  |                     |   | 35 |             | 
|Total                                 |  | $                   | 17,420 |  |                     | $ | 36 |             | 







Total available-for-sale securities have
a fair value of approximately $133.2 million. Of these securities, approximately $17.4 million have unrealized losses when compared
to their amortized cost. All of the securities with the unrealized losses in the available-for-sale portfolio have modest duration
risk, low credit risk, and minimal losses (approximately 0.03%) when compared to total amortized cost. The unrealized losses on
debt securities that exist are the result of market changes in interest rates since original purchase. Because the Company does
not intend to sell these debt securities and it is not more likely than not that the Company will be required to sell these securities
before recovery of their amortized cost bases, which may be at maturity, the Company considers the unrealized losses in the available-for-sale
portfolio to be temporary. There were no unrealized losses in the held-to-maturity securities portfolio at June 30, 2012.





9









The following table provides information
on the amortized cost and estimated fair values of investment securities by maturity date at June 30, 2012.



|                                       |  | Available for sale |         |  | Held to maturity |  
|-------------------------------------- |  | ------------------ | ------- |  | ---------------- | -
|                                       |  | Amortized          |         |  | Estimated        |  
|(Dollars in thousands)                 |  | Cost               |         |  | Fair Value       |  
|Due in one year or less                |  | $                  | 8,012   |  |                  | $
|Due after one year through five years  |  |                    | 14,238  |  |                  |  
|Due after five years through ten years |  |                    | 4,995   |  |                  |  
|Due after ten years                    |  |                    | 102,201 |  |                  |  
|                                       |  |                    | 129,446 |  |                  |  
|Equity securities                      |  |                    | 585     |  |                  |  
|Total                                  |  | $                  | 130,031 |  |                  | $



The maturity dates for debt securities
are determined using contractual maturity dates.



Note 4 – Loans and allowance for
credit losses



The Company makes residential mortgage,
commercial and consumer loans to customers primarily in Talbot County, Queen Anne’s County, Kent County, Caroline County
and Dorchester County in Maryland and in Kent County, Delaware. The following table provides information about the principal classes
of the loan portfolio at June 30, 2012 and December 31, 2011.



|(Dollars in thousands)      |  | June 30, 2012 |         |   | December 31, 2011 |  
|--------------------------- |  | ------------- | ------- | - | ----------------- | -
|Construction                |  | $             | 111,067 |   |                   | $
|Residential real estate     |  |               | 306,093 |   |                   |  
|Commercial real estate      |  |               | 315,644 |   |                   |  
|Commercial                  |  |               | 63,004  |   |                   |  
|Consumer                    |  |               | 14,150  |   |                   |  
|Total loans                 |  |               | 809,958 |   |                   |  
|Allowance for credit losses |  |               | (12,990 | ) |                   |  
|Total loans, net            |  | $             | 796,968 |   |                   | $



Loans are stated at their principal amount
outstanding net of any deferred fees and costs. Interest income on loans is accrued at the contractual rate based on the principal
amount outstanding. Fees charged and costs capitalized for originating loans are being amortized substantially on the interest
method over the term of the loan. A loan is placed on nonaccrual when it is specifically determined to be impaired or when principal
or interest is delinquent for 90 days or more, unless the loan is well secured and in the process of collection. Any unpaid interest
previously accrued on those loans is reversed from income. Interest payments received on nonaccrual loans are applied as a reduction
of the loan principal balance unless collectability of the principal amount is reasonably assured, in which case interest is recognized
on a cash basis. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current
and future payments are reasonably assured.



A loan is considered impaired if it is
probable that the Company will not collect all principal and interest payments according to the loan’s contractual terms.
An impaired loan may show deficiencies in the borrower’s overall financial condition, payment history, support available
from financial guarantors and/or the fair market value of collateral. The impairment of a loan is measured at the present value
of expected future cash flows using the loan’s effective interest rate, or at the loan’s observable market price or
the fair value of the collateral if the loan is collateral dependent. Generally, the Company measures impairment on such loans
by reference to the fair value of the collateral. Income on impaired loans is recognized on a cash basis, and payments are first
applied against the principal balance outstanding (i.e., placing impaired loans on nonaccrual status). Generally, interest income
is not recognized on specific impaired loans unless the likelihood of further loss is remote. The allowance for credit losses includes
specific reserves related to impaired loans. Impaired loans do not include groups of smaller balance homogenous loans such as residential
mortgage and consumer installment loans that are evaluated collectively for impairment. Reserves for probable credit losses related
to these loans are based on historical loss ratios and are included in the formula portion of the allowance for credit losses.





10







Loans are evaluated on a case-by-case basis
for impairment. Once the amount of impairment has been determined, the uncollectible portion is charged off. As seen in the table
below, the difference between the unpaid principal balance and the recorded investment is the amount of partial charge-offs that
have been taken. In some cases, a specific allocation within the allowance for credit losses is made until such time that a charge-off
is made.



A loan is considered a troubled debt restructuring if a borrower
is experiencing financial difficulties and a creditor has granted a concession. Concessions may include
interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other
actions intended to minimize potential losses.



The following tables provide information on impaired loans and
any related allowance by loan class as of June 30, 2012 and December 31, 2011.



|(Dollars in thousands)                |  | Unpaid principal balance |         |  | Recorded investment with no allowance |   |        | Recorded investment with an allowance |  |   | Related allowance |  |  | Average recorded investment |    
|------------------------------------- |  | ------------------------ | ------- |  | ------------------------------------- | - | ------ | ------------------------------------- |  | - | ----------------- |  |  | --------------------------- | ---
|June 30, 2012                         |  |                          |         |  |                                       |   |        |                                       |  |   |                   |  |  |                             |    
|Impaired nonaccrual loans:            |  |                          |         |  |                                       |   |        |                                       |  |   |                   |  |  |                             |    
|Construction                          |  | $                        | 23,220  |  |                                       | $ | 14,258 |                                       |  | $ | -                 |  |  | $                           | -  
|Residential real estate               |  |                          | 24,948  |  |                                       |   | 19,588 |                                       |  |   | 812               |  |  |                             | 420
|Commercial real estate                |  |                          | 15,398  |  |                                       |   | 9,376  |                                       |  |   | 2,260             |  |  |                             | 500
|Commercial                            |  |                          | 2,178   |  |                                       |   | 1,609  |                                       |  |   | -                 |  |  |                             | -  
|Consumer                              |  |                          | 59      |  |                                       |   | 55     |                                       |  |   | -                 |  |  |                             | -  
|Total                                 |  |                          | 65,803  |  |                                       |   | 44,886 |                                       |  |   | 3,072             |  |  |                             | 920
|                                      |  |                          |         |  |                                       |   |        |                                       |  |   |                   |  |  |                             |    
|Impaired accruing restructured loans: |  |                          |         |  |                                       |   |        |                                       |  |   |                   |  |  |                             |    
|Construction                          |  |                          | 17,078  |  |                                       |   | 17,078 |                                       |  |   | -                 |  |  |                             | -  
|Residential real estate               |  |                          | 5,008   |  |                                       |   | 5,008  |                                       |  |   | -                 |  |  |                             | -  
|Commercial real estate                |  |                          | 15,077  |  |                                       |   | 15,077 |                                       |  |   | -                 |  |  |                             | -  
|Commercial                            |  |                          | 68      |  |                                       |   | 68     |                                       |  |   | -                 |  |  |                             | -  
|Consumer                              |  |                          | -       |  |                                       |   | -      |                                       |  |   | -                 |  |  |                             | -  
|Total                                 |  |                          | 37,231  |  |                                       |   | 37,231 |                                       |  |   | -                 |  |  |                             | -  
|                                      |  |                          |         |  |                                       |   |        |                                       |  |   |                   |  |  |                             |    
|Total impaired loans:                 |  |                          |         |  |                                       |   |        |                                       |  |   |                   |  |  |                             |    
|Construction                          |  |                          | 40,298  |  |                                       |   | 31,336 |                                       |  |   | -                 |  |  |                             | -  
|Residential real estate               |  |                          | 29,956  |  |                                       |   | 24,596 |                                       |  |   | 812               |  |  |                             | 420
|Commercial real estate                |  |                          | 30,475  |  |                                       |   | 24,453 |                                       |  |   | 2,260             |  |  |                             | 500
|Commercial                            |  |                          | 2,246   |  |                                       |   | 1,677  |                                       |  |   | -                 |  |  |                             | -  
|Consumer                              |  |                          | 59      |  |                                       |   | 55     |                                       |  |   | -                 |  |  |                             | -  
|Total                                 |  | $                        | 103,034 |  |                                       | $ | 82,117 |                                       |  | $ | 3,072             |  |  | $                           | 920





11









|(Dollars in thousands)                |  | Unpaid principal balance |        |  | Recorded investment with no allowance |   |        | Recorded investment with an allowance |  |   | Related allowance |  |  | Average recorded investment |      
|------------------------------------- |  | ------------------------ | ------ |  | ------------------------------------- | - | ------ | ------------------------------------- |  | - | ----------------- |  |  | --------------------------- | -----
|December 31, 2011                     |  |                          |        |  |                                       |   |        |                                       |  |   |                   |  |  |                             |      
|Impaired nonaccrual loans:            |  |                          |        |  |                                       |   |        |                                       |  |   |                   |  |  |                             |      
|Construction                          |  | $                        | 22,883 |  |                                       | $ | 14,005 |                                       |  | $ | 1,550             |  |  | $                           | 170  
|Residential real estate               |  |                          | 22,431 |  |                                       |   | 16,925 |                                       |  |   | 3,181             |  |  |                             | 1,296
|Commercial real estate                |  |                          | 17,372 |  |                                       |   | 14,012 |                                       |  |   | -                 |  |  |                             | -    
|Commercial                            |  |                          | 2,119  |  |                                       |   | 1,669  |                                       |  |   | -                 |  |  |                             | -    
|Consumer                              |  |                          | 30     |  |                                       |   | 28     |                                       |  |   | -                 |  |  |                             | -    
|Total                                 |  |                          | 64,835 |  |                                       |   | 46,639 |                                       |  |   | 4,731             |  |  |                             | 1,466
|                                      |  |                          |        |  |                                       |   |        |                                       |  |   |                   |  |  |                             |      
|Impaired accruing restructured loans: |  |                          |        |  |                                       |   |        |                                       |  |   |                   |  |  |                             |      
|Construction                          |  |                          | 11,781 |  |                                       |   | 11,781 |                                       |  |   | -                 |  |  |                             | -    
|Residential real estate               |  |                          | 3,792  |  |                                       |   | 3,792  |                                       |  |   | -                 |  |  |                             | -    
|Commercial real estate                |  |                          | 9,566  |  |                                       |   | 9,566  |                                       |  |   | -                 |  |  |                             | -    
|Commercial                            |  |                          | 69     |  |                                       |   | 69     |                                       |  |   | -                 |  |  |                             | -    
|Consumer                              |  |                          | -      |  |                                       |   | -      |                                       |  |   | -                 |  |  |                             | -    
|Total                                 |  |                          | 25,208 |  |                                       |   | 25,208 |                                       |  |   | -                 |  |  |                             | -    
|                                      |  |                          |        |  |                                       |   |        |                                       |  |   |                   |  |  |                             |      
|Total impaired loans:                 |  |                          |        |  |                                       |   |        |                                       |  |   |                   |  |  |                             |      
|Construction                          |  |                          | 34,664 |  |                                       |   | 25,786 |                                       |  |   | 1,550             |  |  |                             | 170  
|Residential real estate               |  |                          | 26,223 |  |                                       |   | 20,717 |                                       |  |   | 3,181             |  |  |                             | 1,296
|Commercial real estate                |  |                          | 26,938 |  |                                       |   | 23,578 |                                       |  |   | -                 |  |  |                             | -    
|Commercial                            |  |                          | 2,188  |  |                                       |   | 1,738  |                                       |  |   | -                 |  |  |                             | -    
|Consumer                              |  |                          | 30     |  |                                       |   | 28     |                                       |  |   | -                 |  |  |                             | -    
|Total                                 |  | $                        | 90,043 |  |                                       | $ | 71,847 |                                       |  | $ | 4,731             |  |  | $                           | 1,466





12







The following tables provide information
on troubled debt restructurings by loan class as of June 30, 2012 and December 31, 2011. The amounts include nonaccrual troubled
debt restructurings.



|(Dollars in thousands)        |  | Number of contracts |    |  | Premodification outstanding
    recorded 
investment |   |        | Postmodification outstanding recorded 
investment | 
|----------------------------- |  | ------------------- | -- |  | ---------------------------------------------------- | - | ------ | ------------------------------------------------- | 
|Troubled debt restructurings: |  |                     |    |  |                                                      |   |        |                                                   | 
|June 30, 2012                 |  |                     |    |  |                                                      |   |        |                                                   | 
|Construction                  |  |                     | 14 |  |                                                      | $ | 21,873 |                                                   | 
|Residential real estate       |  |                     | 26 |  |                                                      |   | 13,530 |                                                   | 
|Commercial real estate        |  |                     | 19 |  |                                                      |   | 21,814 |                                                   | 
|Commercial                    |  |                     | 2  |  |                                                      |   | 125    |                                                   | 
|Consumer                      |  |                     | 1  |  |                                                      |   | 30     |                                                   | 
|Total                         |  |                     | 62 |  |                                                      | $ | 57,372 |                                                   | 
|                              |  |                     |    |  |                                                      |   |        |                                                   | 
|December 31, 2011             |  |                     |    |  |                                                      |   |        |                                                   | 
|Construction                  |  |                     | 9  |  |                                                      | $ | 12,981 |                                                   | 
|Residential real estate       |  |                     | 20 |  |                                                      |   | 11,471 |                                                   | 
|Commercial real estate        |  |                     | 20 |  |                                                      |   | 15,874 |                                                   | 
|Commercial                    |  |                     | 1  |  |                                                      |   | 69     |                                                   | 
|Consumer                      |  |                     | -  |  |                                                      |   | -      |                                                   | 
|Total                         |  |                     | 50 |  |                                                      | $ | 40,395 |                                                   | 





|(Dollars in thousands)                                    |  | Number of contracts |    |  | Recorded investment |  
|--------------------------------------------------------- |  | ------------------- | -- |  | ------------------- | -
|Troubled debt restructurings that subsequently defaulted: |  |                     |    |  |                     |  
|June 30, 2012                                             |  |                     |    |  |                     |  
|Construction                                              |  |                     | 4  |  |                     | $
|Residential real estate                                   |  |                     | 12 |  |                     |  
|Commercial real estate                                    |  |                     | 5  |  |                     |  
|Commercial                                                |  |                     | 1  |  |                     |  
|Consumer                                                  |  |                     | 1  |  |                     |  
|Total                                                     |  |                     | 23 |  |                     | $
|                                                          |  |                     |    |  |                     |  
|December 31, 2011                                         |  |                     |    |  |                     |  
|Construction                                              |  |                     | 3  |  |                     | $
|Residential real estate                                   |  |                     | 10 |  |                     |  
|Commercial real estate                                    |  |                     | 5  |  |                     |  
|Commercial                                                |  |                     | -  |  |                     |  
|Consumer                                                  |  |                     | -  |  |                     |  
|Total                                                     |  |                     | 18 |  |                     | $





13









Management uses risk ratings as part of
its monitoring of the credit quality in the Company’s loan portfolio. Loans that are identified as special mention, substandard
and doubtful are adversely rated and are assigned higher risk ratings than favorably rated loans.



The following tables provide information
on loan risk ratings as of June 30, 2012 and December 31, 2011.



|(Dollars in thousands)  |  | Pass/Performing |         |  | Special mention |   |        | Substandard |  |   | Doubtful |  |  | Nonaccrual |     |  | Total |  
|----------------------- |  | --------------- | ------- |  | --------------- | - | ------ | ----------- |  | - | -------- |  |  | ---------- | --- |  | ----- | -
|June 30, 2012           |  |                 |         |  |                 |   |        |             |  |   |          |  |  |            |     |  |       |  
|Construction            |  | $               | 47,029  |  |                 | $ | 26,633 |             |  | $ | 23,147   |  |  | $          | -   |  |       | $
|Residential real estate |  |                 | 249,611 |  |                 |   | 17,208 |             |  |   | 18,438   |  |  |            | 436 |  |       |  
|Commercial real estate  |  |                 | 257,072 |  |                 |   | 19,447 |             |  |   | 27,489   |  |  |            | -   |  |       |  
|Commercial              |  |                 | 56,049  |  |                 |   | 3,669  |             |  |   | 1,616    |  |  |            | 61  |  |       |  
|Consumer                |  |                 | 13,846  |  |                 |   | 185    |             |  |   | 64       |  |  |            | -   |  |       |  
|Total                   |  | $               | 623,607 |  |                 | $ | 67,142 |             |  | $ | 70,754   |  |  | $          | 497 |  |       | $









|(Dollars in thousands)  |  | Pass/Performing |         |  | Special mention |   |        | Substandard |  |   | Doubtful |  |  | Nonaccrual |     |  | Total |  
|----------------------- |  | --------------- | ------- |  | --------------- | - | ------ | ----------- |  | - | -------- |  |  | ---------- | --- |  | ----- | -
|December 31, 2011       |  |                 |         |  |                 |   |        |             |  |   |          |  |  |            |     |  |       |  
|Construction            |  | $               | 50,403  |  |                 | $ | 30,373 |             |  | $ | 23,552   |  |  | $          | -   |  |       | $
|Residential real estate |  |                 | 261,910 |  |                 |   | 13,467 |             |  |   | 25,676   |  |  |            | 445 |  |       |  
|Commercial real estate  |  |                 | 257,247 |  |                 |   | 16,001 |             |  |   | 28,179   |  |  |            | -   |  |       |  
|Commercial              |  |                 | 59,178  |  |                 |   | 3,813  |             |  |   | 4,748    |  |  |            | 77  |  |       |  
|Consumer                |  |                 | 14,520  |  |                 |   | 32     |             |  |   | 59       |  |  |            | -   |  |       |  
|Total                   |  | $               | 643,258 |  |                 | $ | 63,686 |             |  | $ | 82,214   |  |  | $          | 522 |  |       | $





14







The following tables provide information on the aging
of the loan portfolio as of June 30, 2012 and December 31, 2011.



|                        |  | Accruing |         |   |                     |   |       |                     | 
|----------------------- |  | -------- | ------- | - | ------------------- | - | ----- | ------------------- | 
|(Dollars in thousands)  |  | Current  |         |   | 30-59 days past due |   |       | 60-89 days past due | 
|June 30, 2012           |  |          |         |   |                     |   |       |                     | 
|Construction            |  | $        | 95,937  |   |                     | $ | -     |                     | 
|Residential real estate |  |          | 279,299 |   |                     |   | 4,133 |                     | 
|Commercial real estate  |  |          | 297,782 |   |                     |   | 2,287 |                     | 
|Commercial              |  |          | 61,278  |   |                     |   | 46    |                     | 
|Consumer                |  |          | 13,837  |   |                     |   | 51    |                     | 
|Total                   |  | $        | 748,133 |   |                     | $ | 6,517 |                     | 
|Percent of total loans  |  |          | 92.4    | % |                     |   | 0.8   | %                   | 



|                        |  | Accruing |         |   |                     |   |        |                     | 
|----------------------- |  | -------- | ------- | - | ------------------- | - | ------ | ------------------- | 
|(Dollars in thousands)  |  | Current  |         |   | 30-59 days past due |   |        | 60-89 days past due | 
|December 31, 2011       |  |          |         |   |                     |   |        |                     | 
|Construction            |  | $        | 102,441 |   |                     | $ | 1,246  |                     | 
|Residential real estate |  |          | 289,459 |   |                     |   | 4,417  |                     | 
|Commercial real estate  |  |          | 289,760 |   |                     |   | 10,073 |                     | 
|Commercial              |  |          | 64,581  |   |                     |   | 1,350  |                     | 
|Consumer                |  |          | 14,492  |   |                     |   | 112    |                     | 
|Total                   |  | $        | 760,733 |   |                     | $ | 17,198 |                     | 
|Percent of total loans  |  |          | 90.5    | % |                     |   | 2.0    | %                   | 





15









The Company has established an allowance
for credit losses, which is increased by provisions charged against earnings and recoveries of previously charged-off debts and
is decreased by current period charge-offs of uncollectible debts. Management evaluates the adequacy of the allowance for credit
losses on a quarterly basis and adjusts the provision for credit losses based on this analysis. Allocation of a portion of the
allowance to one loan class does not preclude its availability to absorb losses in other loan classes.



The following tables provide a summary
of the activity in the allowance for credit losses allocated by loan class for the three months ended June 30, 2012 and 2011.



|(Dollars in thousands)                   |  | Construction |       |   | Residential real estate |   |        | Commercial real estate |  |   | Commercial |   |  | Consumer |        |   | Unallocated |   |      | Total | 
|---------------------------------------- |  | ------------ | ----- | - | ----------------------- | - | ------ | ---------------------- |  | - | ---------- | - |  | -------- | ------ | - | ----------- | - | ---- | ----- | 
|For the three months ended
June 30, 2012 |  |              |       |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |      |       | 
|Allowance for credit losses:             |  |              |       |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |      |       | 
|Beginning balance                        |  | $            | 3,344 |   |                         | $ | 4,448  |                        |  | $ | 3,549      |   |  | $        | 1,539  |   |             | $ | 581  |       | 
|                                         |  |              |       |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |      |       | 
|Charge-offs                              |  |              | (714  | ) |                         |   | (1,554 | )                      |  |   | (745       | ) |  |          | (1,085 | ) |             |   | (162 | )     | 
|Recoveries                               |  |              | -     |   |                         |   | 43     |                        |  |   | -          |   |  |          | 133    |   |             |   | 5    |       | 
|Net charge-offs                          |  |              | (714  | ) |                         |   | (1,511 | )                      |  |   | (745       | ) |  |          | (952   | ) |             |   | (157 | )     | 
|                                         |  |              |       |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |      |       | 
|Provision                                |  |              | 215   |   |                         |   | 1,300  |                        |  |   | 1,148      |   |  |          | 476    |   |             |   | 61   |       | 
|Ending balance                           |  | $            | 2,845 |   |                         | $ | 4,237  |                        |  | $ | 3,952      |   |  | $        | 1,063  |   |             | $ | 485  |       | 



|(Dollars in thousands)                   |  | Construction |       |   | Residential real estate |   |        | Commercial real estate |  |   | Commercial |   |  | Consumer |        |   | Unallocated |   |     | Total | 
|---------------------------------------- |  | ------------ | ----- | - | ----------------------- | - | ------ | ---------------------- |  | - | ---------- | - |  | -------- | ------ | - | ----------- | - | --- | ----- | 
|For the three months ended
June 30, 2011 |  |              |       |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |     |       | 
|Allowance for credit losses:             |  |              |       |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |     |       | 
|Beginning balance                        |  | $            | 3,324 |   |                         | $ | 5,420  |                        |  | $ | 5,280      |   |  | $        | 2,776  |   |             | $ | 591 |       | 
|                                         |  |              |       |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |     |       | 
|Charge-offs                              |  |              | (728  | ) |                         |   | (2,390 | )                      |  |   | (2,265     | ) |  |          | (1,525 | ) |             |   | (40 | )     | 
|Recoveries                               |  |              | -     |   |                         |   | 34     |                        |  |   | 5          |   |  |          | 380    |   |             |   | 21  |       | 
|Net charge-offs                          |  |              | (728  | ) |                         |   | (2,356 | )                      |  |   | (2,260     | ) |  |          | (1,145 | ) |             |   | (19 | )     | 
|                                         |  |              |       |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |     |       | 
|Provision                                |  |              | 937   |   |                         |   | 1,120  |                        |  |   | 2,231      |   |  |          | 1,079  |   |             |   | 33  |       | 
|Ending balance                           |  | $            | 3,533 |   |                         | $ | 4,184  |                        |  | $ | 5,251      |   |  | $        | 2,710  |   |             | $ | 605 |       | 





16







The following tables provide a summary
of the activity in the allowance for credit losses allocated by loan class for the six months ended June 30, 2012 and 2011.



|(Dollars in thousands)                 |  | Construction |        |   | Residential real estate |   |        | Commercial real estate |  |   | Commercial |   |  | Consumer |        |   | Unallocated |   |      | Total | 
|-------------------------------------- |  | ------------ | ------ | - | ----------------------- | - | ------ | ---------------------- |  | - | ---------- | - |  | -------- | ------ | - | ----------- | - | ---- | ----- | 
|For the six months ended
June 30, 2012 |  |              |        |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |      |       | 
|Allowance for credit losses:           |  |              |        |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |      |       | 
|Beginning balance                      |  | $            | 3,745  |   |                         | $ | 5,014  |                        |  | $ | 3,415      |   |  | $        | 1,498  |   |             | $ | 594  |       | 
|                                       |  |              |        |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |      |       | 
|Charge-offs                            |  |              | (1,786 | ) |                         |   | (5,673 | )                      |  |   | (1,435     | ) |  |          | (4,440 | ) |             |   | (177 | )     | 
|Recoveries                             |  |              | -      |   |                         |   | 94     |                        |  |   | 7          |   |  |          | 208    |   |             |   | 9    |       | 
|Net charge-offs                        |  |              | (1,786 | ) |                         |   | (5,579 | )                      |  |   | (1,428     | ) |  |          | (4,232 | ) |             |   | (168 | )     | 
|                                       |  |              |        |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |      |       | 
|Provision                              |  |              | 886    |   |                         |   | 4,802  |                        |  |   | 1,965      |   |  |          | 3,797  |   |             |   | 59   |       | 
|Ending balance                         |  | $            | 2,845  |   |                         | $ | 4,237  |                        |  | $ | 3,952      |   |  | $        | 1,063  |   |             | $ | 485  |       | 



|(Dollars in thousands)                 |  | Construction |        |   | Residential real estate |   |        | Commercial real estate |  |   | Commercial |   |  | Consumer |        |   | Unallocated |   |      | Total | 
|-------------------------------------- |  | ------------ | ------ | - | ----------------------- | - | ------ | ---------------------- |  | - | ---------- | - |  | -------- | ------ | - | ----------- | - | ---- | ----- | 
|For the six months ended
June 30, 2011 |  |              |        |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |      |       | 
|Allowance for credit losses:           |  |              |        |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |      |       | 
|Beginning balance                      |  | $            | 3,327  |   |                         | $ | 4,833  |                        |  | $ | 3,665      |   |  | $        | 1,422  |   |             | $ | 637  |       | 
|                                       |  |              |        |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |      |       | 
|Charge-offs                            |  |              | (1,414 | ) |                         |   | (4,481 | )                      |  |   | (2,493     | ) |  |          | (1,771 | ) |             |   | (115 | )     | 
|Recoveries                             |  |              | 49     |   |                         |   | 68     |                        |  |   | 5          |   |  |          | 457    |   |             |   | 41   |       | 
|Net charge-offs                        |  |              | (1,365 | ) |                         |   | (4,413 | )                      |  |   | (2,488     | ) |  |          | (1,314 | ) |             |   | (74  | )     | 
|                                       |  |              |        |   |                         |   |        |                        |  |   |            |   |  |          |        |   |             |   |      |       | 
|Provision                              |  |              | 1,571  |   |                         |   | 3,764  |                        |  |   | 4,074      |   |  |          | 2,602  |   |             |   | 42   |       | 
|Ending balance                         |  | $            | 3,533  |   |                         | $ | 4,184  |                        |  | $ | 5,251      |   |  | $        | 2,710  |   |             | $ | 605  |       | 





17







The following tables include impairment information relating
to loans and the allowance for credit losses as of June 30, 2012 and 2011.



|(Dollars in thousands)                      |  | Construction |         |  | Residential real estate |   |         | Commercial real estate |  |   | Commercial |  |  | Consumer |        |  | Unallocated |   |        | Total | 
|------------------------------------------- |  | ------------ | ------- |  | ----------------------- | - | ------- | ---------------------- |  | - | ---------- |  |  | -------- | ------ |  | ----------- | - | ------ | ----- | 
|June 30, 2012                               |  |              |         |  |                         |   |         |                        |  |   |            |  |  |          |        |  |             |   |        |       | 
|Loans individually evaluated for impairment |  | $            | 31,336  |  |                         | $ | 25,408  |                        |  | $ | 26,713     |  |  | $        | 1,677  |  |             | $ | 55     |       | 
|Loans collectively evaluated for impairment |  |              | 79,731  |  |                         |   | 280,685 |                        |  |   | 288,931    |  |  |          | 61,327 |  |             |   | 14,095 |       | 
|Total loans                                 |  | $            | 111,067 |  |                         | $ | 306,093 |                        |  | $ | 315,644    |  |  | $        | 63,004 |  |             | $ | 14,150 |       | 
|                                            |  |              |         |  |                         |   |         |                        |  |   |            |  |  |          |        |  |             |   |        |       | 
|Allowance for credit losses allocated to:   |  |              |         |  |                         |   |         |                        |  |   |            |  |  |          |        |  |             |   |        |       | 
|Loans individually evaluated for impairment |  | $            | -       |  |                         | $ | 420     |                        |  | $ | 500        |  |  | $        | -      |  |             | $ | -      |       | 
|Loans collectively evaluated for impairment |  |              | 2,845   |  |                         |   | 3,817   |                        |  |   | 3,452      |  |  |          | 1,063  |  |             |   | 485    |       | 
|Total allowance for credit losses           |  | $            | 2,845   |  |                         | $ | 4,237   |                        |  | $ | 3,952      |  |  | $        | 1,063  |  |             | $ | 485    |       | 





|(Dollars in thousands)                      |  | Construction |         |  | Residential real estate |   |         | Commercial real estate |  |   | Commercial |  |  | Consumer |        |  | Unallocated |   |        | Total | 
|------------------------------------------- |  | ------------ | ------- |  | ----------------------- | - | ------- | ---------------------- |  | - | ---------- |  |  | -------- | ------ |  | ----------- | - | ------ | ----- | 
|June 30, 2011                               |  |              |         |  |                         |   |         |                        |  |   |            |  |  |          |        |  |             |   |        |       | 
|Loans individually evaluated for impairment |  | $            | 18,129  |  |                         | $ | 12,187  |                        |  | $ | 15,141     |  |  | $        | 2,990  |  |             | $ | 29     |       | 
|Loans collectively evaluated for impairment |  |              | 110,011 |  |                         |   | 319,947 |                        |  |   | 312,166    |  |  |          | 71,495 |  |             |   | 15,236 |       | 
|Total loans                                 |  | $            | 128,140 |  |                         | $ | 332,134 |                        |  | $ | 327,307    |  |  | $        | 74,485 |  |             | $ | 15,265 |       | 
|                                            |  |              |         |  |                         |   |         |                        |  |   |            |  |  |          |        |  |             |   |        |       | 
|Allowance for credit losses allocated to:   |  |              |         |  |                         |   |         |                        |  |   |            |  |  |          |        |  |             |   |        |       | 
|Loans individually evaluated for impairment |  | $            | -       |  |                         | $ | 289     |                        |  | $ | 506        |  |  | $        | 567    |  |             | $ | -      |       | 
|Loans collectively evaluated for impairment |  |              | 3,533   |  |                         |   | 3,895   |                        |  |   | 4,745      |  |  |          | 2,143  |  |             |   | 605    |       | 
|Total allowance for credit losses           |  | $            | 3,533   |  |                         | $ | 4,184   |                        |  | $ | 5,251      |  |  | $        | 2,710  |  |             | $ | 605    |       | 





18







Note 5 – Other Assets



The Company had the following other assets at June 30, 2012
and December 31, 2011.



|(Dollars in thousands)              |  | June 30, 2012 |        |  | December 31, 2011 |  
|----------------------------------- |  | ------------- | ------ |  | ----------------- | -
|Nonmarketable investment securities |  | $             | 2,874  |  |                   | $
|Insurance premiums receivable       |  |               | 563    |  |                   |  
|Accrued interest receivable         |  |               | 3,644  |  |                   |  
|Income taxes receivable             |  |               | 2,711  |  |                   |  
|Deferred income taxes               |  |               | 8,113  |  |                   |  
|Interest rate caps (1)              |  |               | 68     |  |                   |  
|Prepaid expenses                    |  |               | 3,060  |  |                   |  
|Other assets                        |  |               | 6,010  |  |                   |  
|Total                               |  | $             | 27,043 |  |                   | $



(1) See Note 9 for further discussion.



Note 6 – Other Liabilities



The Company had the following other liabilities at June 30,
2012 and December 31, 2011.



|(Dollars in thousands)   |  | June 30, 2012 |       |  | December 31, 2011 |  
|------------------------ |  | ------------- | ----- |  | ----------------- | -
|Accrued interest payable |  | $             | 588   |  |                   | $
|Other liabilities        |  |               | 8,294 |  |                   |  
|Total                    |  | $             | 8,882 |  |                   | $





19







Note 7 - Stock-Based Compensation



As of June 30, 2012, the Company maintained
the Shore Bancshares, Inc. 2006 Stock and Incentive Compensation Plan (“2006 Equity Plan”) under which it may issue
shares of common stock or grant other equity-based awards. The Company’s ability to grant options under the Shore Bancshares,
Inc. 1998 Stock Option Plan (the “1998 Option Plan”) expired on March 3, 2008 and all of the remaining 7,125 outstanding
options expired on May 9, 2012.



Stock-based awards granted to date generally
are time-based, vest in equal installments on each anniversary of the grant date over a three- to five-year period of time, and,
in the case of stock options, expire 10 years from the grant date. Stock-based compensation expense is recognized ratably over
the requisite service period for all awards, is based on the grant-date fair value and reflects forfeitures as they occur.



During the first quarter of 2012, the Company
granted options to purchase 54,216 shares of the Company’s common stock pursuant to the 2006 Equity Plan. The options have
an exercise price of $6.64 and vest 50% after two years from date of grant and 50% after three years from date of grant.



The following tables provide information
on stock-based compensation expense for the first three and six months of 2012 and 2011.



|                                 |  | For the Three Months Ended |    |  | For the Six Months Ended |  
|-------------------------------- |  | -------------------------- | -- |  | ------------------------ | -
|                                 |  | June 30,                   |    |  | June 30,                 |  
|(Dollars in thousands)           |  | 2012                       |    |  | 2011                     |  
|Stock-based compensation expense |  | $                          | 44 |  |                          | $



|                                                                          |  | June 30, |          
|------------------------------------------------------------------------- |  | -------- | ---------
|(Dollars in thousands)                                                    |  | 2012     |          
|Unrecognized stock-based compensation expense                             |  | $        | 211      
|Weighted average period unrecognized expense is expected to be recognized |  |          | 2.3 years



The following table summarizes restricted
stock award activity for the Company under the 2006 Equity Plan for the six months ended June 30, 2012.



|                                 |  | Number    |         |   | Weighted Average Grant |  
|-------------------------------- |  | --------- | ------- | - | ---------------------- | -
|                                 |  | of Shares |         |   | Date Fair Value        |  
|Nonvested at beginning of period |  |           | 45,779  |   |                        | $
|Granted                          |  |           | -       |   |                        |  
|Vested                           |  |           | (39,231 | ) |                        |  
|Cancelled                        |  |           | -       |   |                        |  
|Nonvested at end of period       |  |           | 6,548   |   |                        | $



The following table summarizes stock option
activity for the Company under the 2006 Equity Plan for the six months ended June 30, 2012.



|                                   |  |           |        |  | Weighted       |   |      | Aggregate |  |   | Weighted Average | 
|---------------------------------- |  | --------- | ------ |  | -------------- | - | ---- | --------- |  | - | ---------------- | 
|                                   |  | Number    |        |  | Average        |   |      | Intrinsic |  |   | Grant Date       | 
|                                   |  | of Shares |        |  | Exercise Price |   |      | Value     |  |   | Fair Value       | 
|Outstanding at beginning of period |  |           | -      |  |                | $ | -    |           |  |   |                  | 
|Granted                            |  |           | 54,216 |  |                |   | 6.64 |           |  |   |                  | 
|Exercised                          |  |           | -      |  |                |   | -    |           |  |   |                  | 
|Expired/Cancelled                  |  |           | -      |  |                |   | -    |           |  |   |                  | 
|Outstanding at end of period       |  |           | 54,216 |  |                | $ | 6.64 |           |  | $ | -                | 
|                                   |  |           |        |  |                |   |      |           |  |   |                  | 
|Exercisable at end of period       |  |           | -      |  |                | $ | -    |           |  | $ | -                | 





20







The Company estimates the fair value of
stock options using the Black-Scholes valuation model with weighted average assumptions for dividend yield, expected volatility,
risk-free interest rate and expected contract life (in years). The expected dividend yield is calculated by dividing the total
expected annual dividend payout by the average stock price. The expected volatility is based on historical volatility of the underlying
securities. The risk-free interest rate is based on the Federal Reserve Bank’s constant maturities daily interest rate in
effect at grant date. The expected contract life of the options represents the period of time that the Company expects the awards
to be outstanding based on historical experience with similar awards. The following weighted average assumptions were used as inputs
to the Black-Scholes valuation model for options granted in 2012.



|Dividend yield                    | 0.60% 
|--------------------------------- | ------
|Expected volatility               | 58.65%
|Risk-free interest rate           | 1.69% 
|Expected contract life (in years) | 5.83  



There was no aggregate intrinsic value
of the options outstanding under the 2006 Equity Plan based on the $5.98 market value per share of Shore Bancshares, Inc.’s
common stock at June 30, 2012. Since there were no options exercised during the first six months of 2012 or 2011, there was no
intrinsic value associated with stock options exercised and no cash received on exercise of options. At June 30, 2012, the weighted
average remaining contract life of options outstanding was 9.7 years.



Note 8 – Fair Value Measurements



Accounting guidance under GAAP defines
fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal
or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement
date. This accounting guidance 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.



The Company utilizes fair value measurements
to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available
for sale and derivative assets and liabilities are recorded at fair value on a recurring basis. Additionally, from time to time,
the Company may be required to record at fair value other assets on a nonrecurring basis, such as impaired loans and other real
estate and other assets owned (foreclosed assets). These nonrecurring fair value adjustments typically involve application of lower
of cost or market accounting or write-downs of individual assets.



Under fair value accounting guidance, assets
and liabilities are grouped at fair value in three levels, based on the markets in which the assets and liabilities are traded
and the reliability of the assumptions used to determine their fair values. These hierarchy levels are:



Level 1 inputs
– Unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access
at the measurement date.



Level 2 inputs
– Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or
indirectly. These might include quoted prices for similar assets or liabilities in active markets, and inputs other than quoted
prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly
quoted intervals.



Level 3 inputs
– Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions
about the assumptions that market participants would use in pricing the assets or liabilities.



Below is a discussion
on the Company’s assets measured at fair value on a recurring basis.



Investment Securities Available for
Sale

Fair value measurement for investment securities
available for sale is based on quoted prices from an independent pricing service. The fair value measurements consider observable
data that may include present value of future cash flows, prepayment assumptions, credit loss assumptions and other factors. The
Company classifies its investments in U.S. Treasury securities as Level 1 in the fair value hierarchy, and it classifies its investments
in U.S. Government agencies securities and mortgage-backed securities issued or guaranteed by U.S. Government sponsored entities
as Level 2.



Derivative Assets

Derivative instruments held by the Company
for risk management purposes are traded in over-the-counter markets where quoted market prices are not readily available. For those
derivatives, the Company measures fair value using third-party models that use primarily market observable inputs, such as yield
curves and option volatilities, and include the value associated with counterparty credit risk. The Company classifies its derivative
instruments held for risk management purposes as Level 2 in the fair value hierarchy. As of June 30, 2012 and December 31, 2011,
the Company’s derivative instruments consisted solely of interest rate caps. These derivative assets are included in other
assets in the accompanying consolidated balance sheets.





21







The tables below present the recorded amount
of assets measured at fair value on a recurring basis at June 30, 2012 and December 31, 2011. No assets were transferred from one
hierarchy level to another during the first six months of 2012 or 2011.



|                               |  |            |         |  |           |   |   | Significant |  |   |              | 
|------------------------------ |  | ---------- | ------- |  | --------- | - | - | ----------- |  | - | ------------ | 
|                               |  |            |         |  |           |   |   | Other       |  |   | Significant  | 
|                               |  |            |         |  | Quoted    |   |   | Observable  |  |   | Unobservable | 
|                               |  |            |         |  | Prices    |   |   | Inputs      |  |   | Inputs       | 
|(Dollars in thousands)         |  | Fair Value |         |  | (Level 1) |   |   | (Level 2)   |  |   | (Level 3)    | 
|June 30, 2012                  |  |            |         |  |           |   |   |             |  |   |              | 
|Securities available for sale: |  |            |         |  |           |   |   |             |  |   |              | 
|U.S. Government agencies       |  | $          | 35,213  |  |           | $ | - |             |  | $ | 35,213       | 
|Mortgage-backed securities     |  |            | 97,414  |  |           |   | - |             |  |   | 97,414       | 
|Other equity securities        |  |            | 617     |  |           |   | - |             |  |   | 617          | 
|Total                          |  | $          | 133,244 |  |           | $ | - |             |  | $ | 133,244      | 
|                               |  |            |         |  |           |   |   |             |  |   |              | 
|Interest rate caps             |  | $          | 68      |  |           | $ | - |             |  | $ | 68           | 



|                               |  |            |         |  |           |   |   | Significant |  |   |              | 
|------------------------------ |  | ---------- | ------- |  | --------- | - | - | ----------- |  | - | ------------ | 
|                               |  |            |         |  |           |   |   | Other       |  |   | Significant  | 
|                               |  |            |         |  | Quoted    |   |   | Observable  |  |   | Unobservable | 
|                               |  |            |         |  | Prices    |   |   | Inputs      |  |   | Inputs       | 
|(Dollars in thousands)         |  | Fair Value |         |  | (Level 1) |   |   | (Level 2)   |  |   | (Level 3)    | 
|December 31, 2011              |  |            |         |  |           |   |   |             |  |   |              | 
|Securities available for sale: |  |            |         |  |           |   |   |             |  |   |              | 
|U.S. Government agencies       |  | $          | 42,148  |  |           | $ | - |             |  | $ | 42,148       | 
|Mortgage-backed securities     |  |            | 87,033  |  |           |   | - |             |  |   | 87,033       | 
|Other equity securities        |  |            | 599     |  |           |   | - |             |  |   | 599          | 
|Total                          |  | $          | 129,780 |  |           | $ | - |             |  | $ | 129,780      | 
|                               |  |            |         |  |           |   |   |             |  |   |              | 
|Interest rate caps             |  | $          | 250     |  |           | $ | - |             |  | $ | 250          | 



Below is a discussion
on the Company’s assets measured at fair value on a nonrecurring basis.



Loans

The Company does not record loans at fair
value on a recurring basis; however, from time to time, a loan is considered impaired and a valuation allowance may be established
if there are losses associated with the loan. Loans are considered impaired if it is probable that payment of interest and principal
will not be made in accordance with contractual terms. The fair value of impaired loans can be estimated using one of several methods,
including the collateral value, market value of similar debt, liquidation value and discounted cash flows. At June 30, 2012 and
December 31, 2011, substantially all impaired loans were evaluated based on the fair value of the collateral and were classified
as Level 3 in the fair value hierarchy.





22







Other Real Estate and Other Assets Owned
(Foreclosed Assets)

Foreclosed assets are adjusted for fair
value upon transfer of loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value and
fair value. Fair value is based on independent market prices, appraised value of the collateral or management’s estimation
of the value of the collateral. At June 30, 2012 and December 31, 2011, foreclosed assets were classified as Level 3 in the fair
value hierarchy.



The tables below summarize the changes
in the recorded amount of assets measured at fair value on a nonrecurring basis for the six months ended June 30, 2012 and June
30, 2011. All assets measured at fair value on a nonrecurring basis were classified as Level 3 in the fair value hierarchy for
the periods presented.



|(Dollars in thousands)                 |  | Construction |        |   | Residential real estate |   |        | Commercial real estate |  |   | Commercial |   |  | Consumer |        |   | Total |  
|-------------------------------------- |  | ------------ | ------ | - | ----------------------- | - | ------ | ---------------------- |  | - | ---------- | - |  | -------- | ------ | - | ----- | -
|For the six months ended June 30, 2012 |  |              |        |   |                         |   |        |                        |  |   |            |   |  |          |        |   |       |  
|Impaired loans:                        |  |              |        |   |                         |   |        |                        |  |   |            |   |  |          |        |   |       |  
|Beginning balance                      |  | $            | 27,166 |   |                         | $ | 22,602 |                        |  | $ | 23,578     |   |  | $        | 1,738  |   |       | $
|Charge-offs                            |  |              | (1,775 | ) |                         |   | (5,356 | )                      |  |   | (1,435     | ) |  |          | (1,264 | ) |       |  
|Payments                               |  |              | (715   | ) |                         |   | (3,185 | )                      |  |   | (1,375     | ) |  |          | (80    | ) |       |  
|Transfers to other real estate owned   |  |              | (1,620 | ) |                         |   | (763   | )                      |  |   | (1,334     | ) |  |          | (30    | ) |       |  
|Returned to performing status          |  |              | -      |   |                         |   | -      |                        |  |   | -          |   |  |          | -      |   |       |  
|Changed to nonaccrual status           |  |              | (666   | ) |                         |   | (786   | )                      |  |   | -          |   |  |          | -      |   |       |  
|Additions                              |  |              | 8,776  |   |                         |   | 11,600 |                        |  |   | 7,279      |   |  |          | 1,313  |   |       |  
|Changes in allowance                   |  |              | 90     |   |                         |   | 876    |                        |  |   | (500       | ) |  |          | (30    | ) |       |  
|Ending balance                         |  | $            | 31,256 |   |                         | $ | 24,988 |                        |  | $ | 26,213     |   |  | $        | 1,647  |   |       | $



|(Dollars in thousands)                 |  | Construction |        |   | Residential real estate |   |        | Commercial real estate |  |   | Commercial |   |  | Consumer |        |   | Total |  
|-------------------------------------- |  | ------------ | ------ | - | ----------------------- | - | ------ | ---------------------- |  | - | ---------- | - |  | -------- | ------ | - | ----- | -
|For the six months ended June 30, 2011 |  |              |        |   |                         |   |        |                        |  |   |            |   |  |          |        |   |       |  
|Impaired loans:                        |  |              |        |   |                         |   |        |                        |  |   |            |   |  |          |        |   |       |  
|Beginning balance                      |  | $            | 28,175 |   |                         | $ | 15,327 |                        |  | $ | 13,280     |   |  | $        | 4,374  |   |       | $
|Charge-offs                            |  |              | (1,396 | ) |                         |   | (4,300 | )                      |  |   | (2,487     | ) |  |          | (1,769 | ) |       |  
|Payments                               |  |              | (837   | ) |                         |   | (4,931 | )                      |  |   | (2,329     | ) |  |          | (542   | ) |       |  
|Transfers to other real estate owned   |  |              | (1,719 | ) |                         |   | (522   | )                      |  |   | (2,577     | ) |  |          | (184   | ) |       |  
|Returned to performing status          |  |              | -      |   |                         |   | (1,907 | )                      |  |   | -          |   |  |          | -      |   |       |  
|Changed to nonaccrual status           |  |              | (419   | ) |                         |   | (2,162 | )                      |  |   | (1,800     | ) |  |          | -      |   |       |  
|Additions                              |  |              | 4,403  |   |                         |   | 18,391 |                        |  |   | 15,723     |   |  |          | 1,111  |   |       |  
|Changes in allowance                   |  |              | -      |   |                         |   | (86    | )                      |  |   | (506       | ) |  |          | (567   | ) |       |  
|Ending balance                         |  | $            | 28,207 |   |                         | $ | 19,810 |                        |  | $ | 19,304     |   |  | $        | 2,423  |   |       | $



|                         |  | For the Six Months Ended |       
|------------------------ |  | ------------------------ | ------
|(Dollars in thousands)   |  | June 30,                 |       
|                         |  | 2012                     |       
|Other real estate owned: |  |                          |       
|Beginning balance        |  | $                        | 9,385 
|Sales                    |  |                          | (1,404
|Write-downs              |  |                          | (853  
|Additions                |  |                          | 4,371 
|Ending balance           |  | $                        | 11,499





23







The following information relates to the
estimated fair values of financial assets and liabilities that are reported in the Company’s consolidated balance sheets
at their carrying amounts. The discussion below describes the methods and assumptions used to estimate the fair value of each class
of financial asset and liability for which it is practicable to estimate that value.



Cash and Cash Equivalents

Cash equivalents include interest-bearing
deposits with other banks and federal funds sold. For these short-term instruments, the carrying amount is a reasonable estimate
of fair value.



Investment Securities Held to Maturity

For all investments in debt securities,
fair values are based on quoted market prices. If a quoted market price is not available, then fair value is estimated using quoted
market prices for similar securities.



Loans

The fair values of categories of fixed
rate loans, such as commercial loans, residential real estate, and other consumer loans, are estimated by discounting the future
cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same
remaining maturities. Other loans, including variable rate loans, are adjusted for differences in loan characteristics.



Financial Liabilities

The fair values of demand deposits, savings
accounts, and certain money market deposits are the amounts payable on demand at the reporting date. The fair value of fixed-maturity
certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. These estimates
do not take into consideration the value of core deposit intangibles. Generally, the carrying amount of short-term borrowings is
a reasonable estimate of fair value. The fair values of securities sold under agreements to repurchase (included in short-term
borrowings) and long-term debt are estimated using the rates offered for similar borrowings.



Commitments to Extend Credit and Standby
Letters of Credit

The majority of the Company’s commitments
to grant loans and standby letters of credit are written to carry current market interest rates if converted to loans. In general,
commitments to extend credit and letters of credit are not assignable by the Company or the borrower, so they generally have value
only to the Company and the borrower. Therefore, it is impractical to assign any value to these commitments.



The following table provides information
on the estimated fair values of the Company’s financial assets and liabilities that are reported at their carrying amounts.
The financial assets and liabilities have been segregated by their classification level in the fair value hierarchy.



|                                       |  | June 30, 2012 |           |  | December 31, 2011 |  
|-------------------------------------- |  | ------------- | --------- |  | ----------------- | -
|                                       |  |               |           |  | Estimated         |  
|                                       |  | Carrying      |           |  | Fair              |  
|(Dollars in thousands)                 |  | Amount        |           |  | Value             |  
|Financial assets                       |  |               |           |  |                   |  
|Level 2 inputs                         |  |               |           |  |                   |  
|Cash and cash equivalents              |  | $             | 169,573   |  |                   | $
|Investment securities held to maturity |  |               | 5,168     |  |                   |  
|Level 3 inputs                         |  |               |           |  |                   |  
|Loans, net                             |  |               | 796,968   |  |                   |  
|                                       |  |               |           |  |                   |  
|Financial liabilities                  |  |               |           |  |                   |  
|Level 2 inputs                         |  |               |           |  |                   |  
|Deposits                               |  | $             | 1,032,703 |  |                   | $
|Short-term borrowings                  |  |               | 13,826    |  |                   |  
|Long-term debt                         |  |               | 455       |  |                   |  



Note 9 – Derivative Instruments
and Hedging Activities



Accounting guidance under GAAP defines
derivatives, requires that derivatives be carried at fair value on the balance sheet and provides for hedge accounting when certain
conditions are met. Changes in the fair values of derivative instruments designated as “cash flow” hedges, to the extent
the hedges are highly effective, are recorded in other comprehensive income, net of taxes. Ineffective portions of cash flow hedges,
if any, are recognized in current period earnings. The net interest settlement on cash flow hedges is treated as an adjustment
of the interest income or interest expense of the hedged assets or liabilities. The Company uses derivative instruments to hedge
its exposure to changes in interest rates. The Company does not use derivatives for any trading or other speculative purposes.





24







During the second quarter
of 2009, as part of its overall interest rate risk management strategy, the Company purchased interest rate caps for $7.1 million
to effectively fix the interest rate at 2.97% for five years on $70 million of the Company’s money market deposit accounts.
The interest rate caps qualified for hedge accounting. The aggregate fair value of these derivatives was an asset of $68 thousand
at June 30, 2012 and $250 thousand at December 31, 2011. The change in fair value included a $780 thousand adjustment to record
unrealized holding gains on the interest rate caps and a $962 thousand charge to interest expense associated with the hedged money
market deposit accounts. For the first six months of 2011, the change in fair value included a $337 thousand adjustment to record
unrealized holding losses and a $559 thousand charge to interest expense. The Company expects that the charge to interest expense
associated with the hedged deposits over the next 12 months will be approximately $2.1 million.



By entering into derivative instrument
contracts, the Company exposes itself, from time to time, to counterparty credit risk. Counterparty credit risk is the risk that
the counterparty will fail to perform under the terms of the derivative contract. When the fair value of a derivative contract
is in an asset position, the counterparty has a liability to the Company, which creates credit risk for the Company. The Company
attempts to minimize this risk by selecting counterparties with investment grade credit ratings, limiting its exposure to any single
counterparty and regularly monitoring its market position with each counterparty. Collateral required by the counterparties, recorded
in other liabilities, was $428 thousand at both June 30, 2012 and December 31, 2011.



Note 10 – Financial Instruments with
Off-Balance Sheet Risk



In the normal
course of business, to meet the financial needs of its customers, the Company’s bank subsidiaries enter into financial instruments
with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit.
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. Letters of credit are conditional commitments issued by the Company to guarantee
the performance of a customer to a third party. Letters of credit and other commitments generally have fixed expiration dates or
other termination clauses and may require payment of a fee. Because many of the letters of credit and commitments are expected
to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements.



The following table provides information on commitments outstanding
at June 30, 2012 and December 31, 2011.



|(Dollars in thousands)       |  | June 30, 2012 |         |  | December 31, 2011 |  
|---------------------------- |  | ------------- | ------- |  | ----------------- | -
|Commitments to extend credit |  | $             | 146,547 |  |                   | $
|Letters of credit            |  |               | 12,013  |  |                   |  
|Total                        |  | $             | 158,560 |  |                   | $



Note 11 – Segment Reporting



The Company operates
two primary business segments: Community Banking and Insurance Products and Services. Through the Community Banking business, the
Company provides services to consumers and small businesses on the Eastern Shore of Maryland and Delaware through its 18-branch
network. Community banking activities include small business services, retail brokerage, trust services and consumer banking products
and services. Loan products available to consumers include mortgage, home equity, automobile, marine, and installment loans, credit
cards and other secured and unsecured personal lines of credit. Small business lending includes commercial mortgages, real estate
development loans, equipment and operating loans, as well as secured and unsecured lines of credit, credit cards, accounts receivable
financing arrangements, and merchant card services.



Through the Insurance Products and Services
business, the Company provides a full range of insurance products and services to businesses and consumers in the Company’s
market areas. Products include property and casualty, life, marine, individual health and long-term care insurance. Pension and
profit sharing plans and retirement plans for executives and employees are available to suit the needs of individual businesses.





25







The following table includes selected financial information
by business segments for the first six months of 2012 and 2011.



|                                  |  | Community |           |   | Insurance Products |   |        | Parent  |  |   | Consolidated |  
|--------------------------------- |  | --------- | --------- | - | ------------------ | - | ------ | ------- |  | - | ------------ | -
|(Dollars in thousands)            |  | Banking   |           |   | and Services       |   |        | Company |  |   | Total        |  
|2012                              |  |           |           |   |                    |   |        |         |  |   |              |  
|Interest income                   |  | $         | 23,509    |   |                    | $ | 39     |         |  | $ | -            |  
|Interest expense                  |  |           | (5,309    | ) |                    |   | -      |         |  |   | (11          | )
|Provision for credit losses       |  |           | (11,895   | ) |                    |   | -      |         |  |   | -            |  
|Noninterest income                |  |           | 3,706     |   |                    |   | 5,395  |         |  |   | 50           |  
|Noninterest expense               |  |           | (12,157   | ) |                    |   | (4,967 | )       |  |   | (3,037       | )
|Net intersegment (expense) income |  |           | (2,687    | ) |                    |   | (257   | )       |  |   | 2,944        |  
|(Loss) income before taxes        |  |           | (4,833    | ) |                    |   | 210    |         |  |   | (54          | )
|Income tax benefit (expense)      |  |           | 2,001     |   |                    |   | (89    | )       |  |   | 22           |  
|Net (loss) income                 |  | $         | (2,832    | ) |                    | $ | 121    |         |  | $ | (32          | )
|                                  |  |           |           |   |                    |   |        |         |  |   |              |  
|Total assets                      |  | $         | 1,156,644 |   |                    | $ | 16,903 |         |  | $ | 1,786        |  
|                                  |  |           |           |   |                    |   |        |         |  |   |              |  
|                                  |  |           |           |   |                    |   |        |         |  |   |              |  
|2011                              |  |           |           |   |                    |   |        |         |  |   |              |  
|Interest income                   |  | $         | 25,387    |   |                    | $ | 66     |         |  | $ | -            |  
|Interest expense                  |  |           | (5,628    | ) |                    |   | -      |         |  |   | (21          | )
|Provision for credit losses       |  |           | (11,785   | ) |                    |   | -      |         |  |   | -            |  
|Noninterest income                |  |           | 3,422     |   |                    |   | 5,284  |         |  |   | 70           |  
|Noninterest expense               |  |           | (11,390   | ) |                    |   | (4,743 | )       |  |   | (2,952       | )
|Net intersegment (expense) income |  |           | (2,876    | ) |                    |   | (244   | )       |  |   | 3,120        |  
|(Loss) income before taxes        |  |           | (2,870    | ) |                    |   | 363    |         |  |   | 217          |  
|Income tax benefit (expense)      |  |           | 1,220     |   |                    |   | (154   | )       |  |   | (92          | )
|Net (loss) income                 |  | $         | (1,650    | ) |                    | $ | 209    |         |  | $ | 125          |  
|                                  |  |           |           |   |                    |   |        |         |  |   |              |  
|Total assets                      |  | $         | 1,102,389 |   |                    | $ | 18,933 |         |  | $ | 2,869        |  





26







Item 2. Management’s Discussion
and Analysis of Financial Condition and Results of Operations.



Unless the context clearly suggests otherwise,
references to “the Company”, “we”, “our”, and “us” in the remainder of this report
are to Shore Bancshares, Inc. and its consolidated subsidiaries.



Forward-Looking Information

Portions of this Quarterly Report on Form
10-Q contain forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. Statements
that are not historical in nature, including statements that include the words “anticipate”, “estimate”,
“should”, “expect”, “believe”, “intend”, and similar expressions, are expressions
about our confidence, policies, and strategies, the adequacy of capital levels, and liquidity and are not guarantees of future
performance. Such forward-looking statements involve certain risks and uncertainties, including economic conditions, competition
in the geographic and business areas in which we operate, inflation, fluctuations in interest rates, legislation, and governmental
regulation. These risks and uncertainties are described in detail in the section of the periodic reports that Shore Bancshares,
Inc. files with the Securities and Exchange Commission (the “SEC”) entitled “Risk Factors” (see Item 1A
of Part II of this report). Actual results may differ materially from such forward-looking statements, and we assume no obligation
to update forward-looking statements at any time except as required by law.



Introduction

The following discussion and analysis is
intended as a review of significant factors affecting the Company’s financial condition and results of operations for the
periods indicated. This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements
and related notes presented in this report, as well as the audited consolidated financial statements and related notes included
in the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2011.



Shore Bancshares, Inc. is the largest independent
financial holding company located on the Eastern Shore of Maryland. It is the parent company of The Talbot Bank of Easton, Maryland
located in Easton, Maryland (“Talbot Bank”) and CNB located in Centreville, Maryland (together with Talbot Bank, the
“Banks”). Until January 1, 2011, the Company also served as the parent company to The Felton Bank located in Felton,
Delaware. On January 1, 2011, The Felton Bank merged into CNB, with CNB as the surviving bank. The Banks operate 18 full service
branches in Kent County, Queen Anne’s County, Talbot County, Caroline County and Dorchester County in Maryland and Kent County,
Delaware. The Company engages in the insurance business through three insurance producer firms, The Avon-Dixon Agency, LLC, Elliott
Wilson Insurance, LLC and Jack Martin Associates, Inc.; a wholesale insurance company, TSGIA, Inc.; and two insurance premium finance
companies, Mubell Finance, LLC and ESFS, Inc. (all of the foregoing are collectively referred to as the “Insurance Subsidiary”).
Each of these entities is a wholly-owned subsidiary of Shore Bancshares, Inc. The Company engages in the mortgage brokerage business
under the name “Wye Mortgage Group” through a minority series investment in an unrelated Delaware limited liability
company.



The shares of common stock of Shore Bancshares,
Inc. are listed on the NASDAQ Global Select Market under the symbol “SHBI”.



Shore Bancshares, Inc. maintains an Internet
site at www.shbi.com on which it makes available free of charge its Annual Report on Form 10-K, Quarterly Reports on Form
10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are
electronically filed with, or furnished to, the SEC.



Critical Accounting Policies

Our financial statements are prepared in
accordance with accounting principles generally accepted in the United States of America (“GAAP”). The financial information
contained within the financial statements is, to a significant extent, financial information contained that is based on measures
of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate
value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability.



Allowance for Credit Losses

The allowance for credit losses is an estimate
of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) Topic
450, “Contingencies”, of the Financial Accounting Standards Board’s Accounting Standards Codification
(“ASC”), which requires that losses be accrued when they are probable of occurring and estimable; and (ii) ASC Topic
310, “Receivables”, which requires that losses be accrued based on the differences between the loan balance
and the value of collateral, present value of future cash flows or values that are observable in the secondary market. Management
uses many factors to estimate the inherent loss that may be present in our loan portfolio, including economic conditions and trends,
the value and adequacy of collateral, the volume and mix of the loan portfolio, and our internal loan processes. Actual losses
could differ significantly from management’s estimates. In addition, GAAP itself may change from one previously acceptable
method to another. Although the economics of transactions would be the same, the timing of events that would impact the transactions
could change.





27







Three basic components comprise our allowance
for credit losses: (i) a specific allowance; (ii) a formula allowance; and (iii) a nonspecific allowance. Each component is determined
based on estimates that can and do change when the actual events occur. The specific allowance is established against impaired
loans (i.e., nonaccrual loans and troubled debt restructurings) based on our assessment of the losses that may be associated with
the individual loans. The specific allowance remains until charge-offs are made. An impaired loan may show deficiencies in the
borrower’s overall financial condition, payment history, support available from financial guarantors and/or the fair market
value of collateral. The formula allowance is used to estimate the loss on internally risk-rated loans, exclusive of those identified
as impaired. Loans are grouped by type (construction, commercial real estate, residential real estate, commercial or consumer).
Each loan type is assigned an allowance factor based on management’s estimate of the risk, complexity and size of individual
loans within a particular category. Loans identified as special mention, substandard, and doubtful are adversely rated. These loans
are assigned higher allowance factors than favorably rated loans due to management’s concerns regarding collectability or
management’s knowledge of particular elements regarding the borrower. The nonspecific allowance captures losses that have
impacted the portfolio but have yet to be recognized in either the specific or formula allowance.



Management has significant discretion in
making the adjustments inherent in the determination of the provision and allowance for credit losses, including in connection
with the valuation of collateral, the estimation of a borrower’s prospects of repayment, and the establishment of the allowance
factors on the formula allowance and unallocated allowance components of the allowance. The establishment of allowance factors
is a continuing exercise, based on management’s ongoing assessment of the totality of all factors, including, but not limited
to, delinquencies, loss history, trends in volume and terms of loans, effects of changes in lending policy, the experience and
depth of management, national and local economic trends, concentrations of credit, the quality of the loan review system and the
effect of external factors such as competition and regulatory requirements, and their impact on the portfolio. Allowance factors
may change from period to period, resulting in an increase or decrease in the amount of the provision or allowance, based on the
same volume and classification of loans. Changes in allowance factors will have a direct impact on the amount of the provision,
and a corresponding effect on net income. Errors in management’s perception and assessment of these factors and their impact
on the portfolio could result in the allowance not being adequate to cover losses in the portfolio, and may result in additional
provisions or charge-offs.



Goodwill and Other Intangible Assets

Goodwill represents the excess of the cost
of an acquisition over the fair value of the net assets acquired. Other intangible assets represent purchased assets that also
lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset
is capable of being sold or exchanged either on its own or in combination with a related contract, asset or liability. Goodwill
and other intangible assets with indefinite lives are tested at least annually for impairment, usually during the third quarter,
or on an interim basis if circumstances dictate. Intangible assets that have finite lives are amortized over their estimated useful
lives and also are subject to impairment testing.



Impairment testing requires that the fair
value of each of the Company’s reporting units be compared to the carrying amount of its net assets, including goodwill.
The Company’s reporting units were identified based on an analysis of each of its individual operating segments. If the fair
value of a reporting unit is less than book value, an expense may be required to write down the related goodwill or purchased intangibles
to record an impairment loss.



Fair Value

The Company measures certain financial
assets and liabilities at fair value. Significant financial assets measured at fair value on a recurring basis are investment securities
and interest rate caps. Impaired loans and other real estate owned are significant financial assets measured at fair value on a
nonrecurring basis. See Note 8, “Fair Value Measurements”, in the Notes to Consolidated Financial Statements for a
further discussion of fair value.





OVERVIEW



The Company reported net income of $293
thousand for the second quarter of 2012, or diluted income per common share of $0.03, compared to a net loss of $233 thousand,
or diluted loss per common share of $(0.03), for the second quarter of 2011. For the first quarter of 2012, the Company reported
a net loss of $3.0 million, or diluted loss per common share of $(0.36). The provision for credit losses for the second quarter
of 2012 was $3.5 million, which was $1.9 million and $4.8 million lower than the provision for the second quarter of 2011 and the
first quarter of 2012, respectively. Annualized return on average assets was 0.10% for the three months ended June 30, 2012, compared
to (0.08)% for the same period in 2011. Annualized return on average stockholders’ equity was 0.99% for the second quarter
of 2012, compared to (0.77)% for the second quarter of 2011. For the first quarter of 2012, annualized return on average assets
was (1.05)% and return on average equity was (10.04)%.





28







For the first six months of 2012, the Company
reported a net loss of $2.7 million, or diluted loss per common share of $(0.32), compared to a net loss of $1.3 million, or diluted
loss per common share of $(0.16), for the first six months of 2011. Annualized return on average assets was (0.47)% for the six
months ended June 30, 2012, compared to (0.24)% for the same period in 2011. Annualized return on average stockholders’ equity
was (4.59)% for the first six months of 2012, compared to (2.18)% for the first six months of 2011.





RESULTS OF OPERATIONS



Net Interest Income

Net interest income for the second quarter
of 2012 was $9.0 million, compared to $9.9 million for the second quarter of 2011 and $9.2 million for the first quarter of 2012.
The decrease in net interest income when compared to the second quarter of 2011 and the first quarter of 2012 was primarily due
to lower yields earned on average earning assets and a decline in higher-yielding average loan balances. The net interest margin
was 3.36% for the second quarter of 2012, 3.80% for the second quarter of 2011 and 3.42% for the first quarter of 2012, a decrease
of 44 basis points and 6 basis points, respectively. Loan charge-offs continued to negatively impact our net interest income and
net interest margin.



Interest income was $11.7 million for
the second quarter of 2012, a decrease of 8.2% from the second quarter of 2011. Average earning assets (loans, investment securities,
federal funds sold and interest-bearing deposits with other banks) increased 2.8% during the second quarter of 2012 when compared
to the same period in 2011, while yields earned decreased 51 basis points to 4.35%, mainly due to loan activity. Average loans
decreased 7.4% and the yield earned on loans decreased 5 basis points from 5.43% to 5.38%. Loans comprised 75.2% of total average
earning assets for the second quarter of 2012, compared to 83.5% for the second quarter of 2011. Taxable investment securities
grew $23.9 million, or 22.4%, although yields declined 76 basis points because the reinvestment rates on investment securities
purchased during 2012 were lower than the yields on the investment securities that matured during the period. Excess cash shifted
from federal funds sold (decreasing $13.1 million) to interest-bearing deposits (increasing $85.0 million) to take advantage of
higher yields on interest-bearing deposits. Interest income decreased 1.4% when compared to the first quarter of 2012. Average
earning assets remained relatively unchanged during the second quarter of 2012 when compared to the first quarter of 2012, and
yields earned declined 5 basis points.



Interest expense was $2.7 million for the
three months ended June 30, 2012, a decrease of 4.8% when compared to the same period last year. Average interest-bearing liabilities
(deposits and borrowings) increased 2.8% while rates paid decreased 9 basis points to 1.20%, primarily due to changes in time deposits
(certificates of deposit $100,000 or more and other time deposits). For the three months ended June 30, 2012, the average balance
of certificates of deposit $100,000 or more and other time deposits each decreased approximately 1.0% when compared to the same
period last year, and the average rate paid on these time deposits decreased 21 and 29 basis points, respectively, reflecting current
market conditions. The decrease in average time deposits was more than offset by an increase in interest-bearing demand deposits
(10.8%) and money market and savings deposits (5.6%), reflecting a shift in customer investment needs. Interest on money market
and savings deposits included an adjustment to expense related to interest rate caps and the hedged deposits associated with them.
This adjustment increased interest expense $502 thousand for the second quarter of 2012 and $299 thousand for the second quarter
of 2011. See Note 9, “Derivative Instruments and Hedging Activities”, in the Notes to Consolidated Financial Statements
for additional information. When comparing the second quarter of 2012 to the first quarter of 2012, interest expense remained relatively
unchanged with average balances of total interest-bearing liabilities decreasing less than 1.0% and the interest rate paid on interest-bearing
liabilities staying at 1.20%.



Net interest income for the six months
ended June 30, 2012 was $18.2 million, a decrease of 8.0% when compared to the same period last year. As with the quarterly results,
the decrease was mainly due to lower yields earned on average earning assets and a decline in higher-yielding average loan balances.
The net interest margin was 3.39% for the first six months of 2012 and 3.79% for the first six months of 2011.



Interest income was $23.5 million for the
first six months of 2012, a decrease of 7.5% when compared to the first six months of 2011. Average earning assets increased 2.6%
during the six months ended June 30, 2012 when compared to the same period in 2011, while yields earned decreased 50 basis points
to 4.37% primarily due to the impact of loan activity. When comparing the six-month period ended June 30, 2012 to the same period
of last year, average loans decreased 6.8% and the yield earned on loans decreased 11 basis points. Loans comprised 75.9% and 83.5%
of total average earning assets for the first six months of 2012 and 2011, respectively.





29







Interest expense was $5.3 million for the
six months ended June 30, 2012, a decrease of 5.8% when compared to the same period last year. Average interest-bearing liabilities
increased 2.4%, while rates paid decreased 11 basis points to 1.20% primarily due to time deposit activity. For the six months
ended June 30, 2012, the average balance of certificates of deposit $100,000 or more and other time deposits decreased 4.1% and
1.9%, respectively, when compared to the same period last year, and the average rate paid on these deposits decreased 23 and 28
basis points, respectively.



Analysis of Interest Rates and Interest
Differentials

The following table presents the distribution
of the average consolidated balance sheets, interest income/expense, and annualized yields earned and rates paid for the three
months ended June 30, 2012 and 2011.



|                                           |  | For the Three Months Ended |           |   | For the Three Months Ended |  
|------------------------------------------ |  | -------------------------- | --------- | - | -------------------------- | -
|                                           |  | June 30, 2012              |           |   | June 30, 2011              |  
|                                           |  | Average                    |           |   | Income(1)/                 |  
|(Dollars in thousands)                     |  | Balance                    |           |   | Expense                    |  
|Earning assets                             |  |                            |           |   |                            |  
|Loans (2), (3)                             |  | $                          | 816,553   |   |                            | $
|Investment securities                      |  |                            |           |   |                            |  
|Taxable                                    |  |                            | 130,528   |   |                            |  
|Tax-exempt                                 |  |                            | 3,771     |   |                            |  
|Federal funds sold                         |  |                            | 11,200    |   |                            |  
|Interest-bearing deposits                  |  |                            | 124,171   |   |                            |  
|Total earning assets                       |  |                            | 1,086,223 |   |                            |  
|Cash and due from banks                    |  |                            | 21,424    |   |                            |  
|Other assets                               |  |                            | 70,458    |   |                            |  
|Allowance for credit losses                |  |                            | (14,507   | ) |                            |  
|Total assets                               |  | $                          | 1,163,598 |   |                            |  
|                                           |  |                            |           |   |                            |  
|Interest-bearing liabilities               |  |                            |           |   |                            |  
|Demand deposits                            |  | $                          | 152,685   |   |                            |  
|Money market and savings deposits (4)      |  |                            | 276,527   |   |                            |  
|Certificates of deposit $100,000 or more   |  |                            | 242,662   |   |                            |  
|Other time deposits                        |  |                            | 205,046   |   |                            |  
|Interest-bearing deposits                  |  |                            | 876,920   |   |                            |  
|Short-term borrowings                      |  |                            | 13,818    |   |                            |  
|Long-term debt                             |  |                            | 455       |   |                            |  
|Total interest-bearing liabilities         |  |                            | 891,193   |   |                            |  
|Noninterest-bearing deposits               |  |                            | 144,210   |   |                            |  
|Other liabilities                          |  |                            | 9,421     |   |                            |  
|Stockholders’ equity                       |  |                            | 118,774   |   |                            |  
|Total liabilities and stockholders’ equity |  | $                          | 1,163,598 |   |                            |  
|                                           |  |                            |           |   |                            |  
|Net interest spread                        |  |                            |           |   |                            | $
|Net interest margin                        |  |                            |           |   |                            |  
|                                           |  |                            |           |   |                            |  
|Tax-equivalent adjustment                  |  |                            |           |   |                            |  
|Loans                                      |  |                            |           |   |                            | $
|Investment securities                      |  |                            |           |   |                            |  
|Total                                      |  |                            |           |   |                            | $





|(1) | All amounts are reported on a tax equivalent basis computed using the statutory federal income tax rate of 34.0% for 2012 and 2011 exclusive of the alternative minimum tax rate and nondeductible interest expense.                                                                                  
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(2) | Average loan balances include nonaccrual loans.                                                                                                                                                                                                                                                       
|(3) | Interest income on loans includes amortized loan fees, net of costs, and all are included in the yield calculations.                                                                                                                                                                                  
|(4) | Interest on money market and savings deposits includes an adjustment to expense related to interest rate caps and the hedged deposits associated with them.  This adjustment increased interest expense $502 thousand for the second quarter of 2012 and $299 thousand for the second quarter of 2011.







30







The following table presents the distribution
of the average consolidated balance sheets, interest income/expense, and annualized yields earned and rates paid for the six months
ended June 30, 2012 and 2011:



|                                           |  | For the Three Months Ended |           |   | For the Three Months Ended |  
|------------------------------------------ |  | -------------------------- | --------- | - | -------------------------- | -
|                                           |  | June 30, 2012              |           |   | June 30, 2011              |  
|                                           |  | Average                    |           |   | Income(1)/                 |  
|(Dollars in thousands)                     |  | Balance                    |           |   | Expense                    |  
|Earning assets                             |  |                            |           |   |                            |  
|Loans (2), (3)                             |  | $                          | 824,569   |   |                            | $
|Investment securities                      |  |                            |           |   |                            |  
|Taxable                                    |  |                            | 130,148   |   |                            |  
|Tax-exempt                                 |  |                            | 4,020     |   |                            |  
|Federal funds sold                         |  |                            | 10,497    |   |                            |  
|Interest-bearing deposits                  |  |                            | 117,931   |   |                            |  
|Total earning assets                       |  |                            | 1,087,165 |   |                            |  
|Cash and due from banks                    |  |                            | 19,799    |   |                            |  
|Other assets                               |  |                            | 69,310    |   |                            |  
|Allowance for credit losses                |  |                            | (14,692   | ) |                            |  
|Total assets                               |  | $                          | 1,161,582 |   |                            |  
|                                           |  |                            |           |   |                            |  
|Interest-bearing liabilities               |  |                            |           |   |                            |  
|Demand deposits                            |  | $                          | 152,988   |   |                            |  
|Money market and savings deposits (4)      |  |                            | 277,941   |   |                            |  
|Certificates of deposit $100,000 or more   |  |                            | 241,591   |   |                            |  
|Other time deposits                        |  |                            | 203,394   |   |                            |  
|Interest-bearing deposits                  |  |                            | 875,914   |   |                            |  
|Short-term borrowings                      |  |                            | 15,720    |   |                            |  
|Long-term debt                             |  |                            | 455       |   |                            |  
|Total interest-bearing liabilities         |  |                            | 892,089   |   |                            |  
|Noninterest-bearing deposits               |  |                            | 140,235   |   |                            |  
|Other liabilities                          |  |                            | 9,042     |   |                            |  
|Stockholders’ equity                       |  |                            | 120,216   |   |                            |  
|Total liabilities and stockholders’ equity |  | $                          | 1,161,582 |   |                            |  
|                                           |  |                            |           |   |                            |  
|Net interest spread                        |  |                            |           |   |                            | $
|Net interest margin                        |  |                            |           |   |                            |  
|                                           |  |                            |           |   |                            |  
|Tax-equivalent adjustment                  |  |                            |           |   |                            |  
|Loans                                      |  |                            |           |   |                            | $
|Investment securities                      |  |                            |           |   |                            |  
|Total                                      |  |                            |           |   |                            | $







|(1) | All amounts are reported on a tax equivalent basis computed using the statutory federal income tax rate of 34.0% for 2012 and 2011 exclusive of the alternative minimum tax rate and nondeductible interest expense.                                                                                      
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(2) | Average loan balances include nonaccrual loans.                                                                                                                                                                                                                                                           
|(3) | Interest income on loans includes amortized loan fees, net of costs, and all are included in the yield calculations.                                                                                                                                                                                      
|(4) | Interest on money market and savings deposits includes an adjustment to expense related to interest rate caps and the hedged deposits associated with them.  This adjustment increased interest expense $962 thousand for the first six months of 2012 and $559 thousand for the first six months of 2011.







Noninterest Income

Noninterest income for the second quarter
of 2012 increased $196 thousand, or 4.5%, when compared to the second quarter of 2011. The higher amount was primarily the result
of an increase in other noninterest income which included a $217 thousand gain on the sale of a bank branch building. This increase
was partially offset by a decline in insurance agency commissions and service charges on deposit accounts which were impacted by
a decrease in customer use of overdraft protection programs. Total noninterest income for the second quarter of 2012 remained relatively
unchanged when compared to the first quarter of 2012. The slightly higher amount when compared to the first quarter of 2012 was
primarily the result of the $217 thousand gain on the sale of a bank branch building which was mainly offset by a decrease in insurance
agency commissions due to the fact that contingency payments are typically received in the first quarter of the year.







31







Total noninterest
income for the six months ended June 30, 2012 increased $375 thousand, or 4.3%, when compared to the same period in 2011, primarily
due to higher insurance agency commissions ($110 thousand) and other noninterest income ($449 thousand). Other noninterest income
includedthe $217 thousand gain on the sale of a bank branch building and a $96 thousand increase in rental income from
other real estate owned properties. Partially offsetting the increase in noninterest income was a decline in service charges on
deposit accounts.



Noninterest Expense

Noninterest expense for the second quarter
of 2012 increased $469 thousand, or 5.1%, when compared to the second quarter of 2011, mostly due to higher salaries and wages
and other noninterest expenses. Salaries and wages increased $272 thousand, mainly due to the hiring of a new executive vice president
at The Talbot Bank of Easton, Maryland during the second quarter of last year as part of that bank’s succession plan, and
a new lender at CNB for the Delaware region during the third quarter of last year. Other noninterest expenses increased $212 thousand,
primarily due to higher expenses related to other real estate owned activities. Total noninterest expense for the second quarter
of 2012 decreased $835 thousand, or 8.0%, when compared to the first quarter of 2012, primarily due to lower employee benefits
and other noninterest expenses. Other employee benefits decreased $214 thousand, mainly due to lower payroll taxes. Other noninterest
expenses decreased $539 thousand, mostly due to lower expenses related to other real estate owned activities ($323 thousand) and
employee training ($96 thousand), primarily on the use of upgraded insurance software during the first quarter of 2012.



Total noninterest
expense for the six months ended June 30, 2012 increased $1.1 million, or 5.6%, when compared to the same period in 2011. The increase
was primarily due to higher salaries and wages and other noninterest expenses which included larger expenses relating to
other real estate owned activities and employee training. These expenses were partially offset by lower FDIC insurance premiums
and data processing charges due to the merger of The Felton Bank into CNB during the first quarter of 2011.



Income Taxes

The Company reported income tax expense
of $129 thousand for the second quarter of 2012 and an income tax benefit of $33 thousand for the second quarter of 2011. The effective
tax rate was a 30.6% expense for the second quarter of 2012 and a 12.4% benefit for the second quarter of 2011. The effective tax
rate for the second quarter of 2011 was impacted by a disallowed exclusion for U.S. Government agency securities income. The Company
reported an income tax benefit of $1.9 million and $974 thousand for the first six months of 2012 and 2011, respectively. The effective
tax rate for the six months ended June 30, 2011 was a 41.4% benefit, compared to a 42.5% benefit for the same period of 2011.





ANALYSIS OF FINANCIAL
CONDITION



Loans

Loans totaled $810.0 million at June 30,
2012, a $31.1 million, or 3.7%, decrease from the $841.1 million at December 31, 2011. Loans included deferred costs net of deferred
fees of $225 thousand at June 30, 2012 and $188 thousand at December 31, 2011. Residential real estate loans declined the most
($15.5 million) followed by construction ($8.8 million) and commercial loans ($6.5 million). Commercial real estate loans remained
relatively unchanged since the end of 2011 while consumer loans decreased $489 thousand. Fewer high-quality loan opportunities
and our level of loan charge-offs continue to deter loan growth. See Note 4, “Loans and Allowance for Credit Losses”,
in the Notes to Consolidated Financial Statements and below under the caption “Allowance for Credit Losses” for additional
information.



Our loan portfolio has a commercial real
estate loan concentration, which is defined as a combination of construction and commercial real estate loans. Construction loans
were $111.1 million, or 13.7% of total loans, at June 30, 2012, compared to $119.9 million, or 14.3% of total loans, at December
31, 2011. Commercial real estate loans were approximately $315.6 million, or 39.0% of total loans, at June 30, 2012, compared to
$315.4 million, or 37.5% of total loans, at December 31, 2011. We do not engage in foreign or subprime lending activities.



Because most of our loans are secured by
real estate, the lack of a meaningful upturn in real estate related activities in our local real estate market and construction
industry and slow improvement in general economic conditions have had a material adverse effect on the performance of our loan
portfolio and the value of the collateral securing that portfolio. Factors impeding our loan performance and overall financial
performance include our levels of loan charge-offs and provisions for credit losses.





32









Allowance for Credit Losses

We have established an allowance for credit
losses, which is increased by provisions charged against earnings and recoveries of previously charged-off debts and is decreased
by current period charge-offs of uncollectible debts. Management evaluates the adequacy of the allowance for credit losses on a
quarterly basis and adjusts the provision for credit losses based on this analysis. The evaluation of the adequacy of the allowance
for credit losses is based primarily on a risk rating system of individual loans, as well as on a collective evaluation of smaller
balance homogenous loans, each grouped by loan type. Each loan type is assigned allowance factors based on criteria such as past
credit loss experience, local economic and industry trends, and other measures which may impact collectibility. Please refer to
the discussion above under the caption “Critical Accounting Policies” for an overview of the underlying methodology
management employs to maintain the allowance.



The provision for credit losses was $3.5
million for the second quarter of 2012, $5.4 million for the second quarter of 2011 and $8.4 million for the first quarter of 2012,
respectively. The lower level of provision for credit losses was primarily in response to lower loan
charge-offs. The provision for credit losses for the first six months of 2012 and 2011 was $11.9 million and $11.8 million,
respectively. Because most of our loans are secured by real estate, historically low property values and real estate sales are
negatively impacting credit quality. Nevertheless, we continue to emphasize credit quality and believe that our underwriting guidelines
are strong. When problem loans are identified, management takes prompt action to quantify and minimize losses in its focused efforts
to dispose of existing problem loans. Management also works with borrowers in an effort to reach mutually acceptable resolutions.



Net charge-offs for the second quarter
of 2012 and for the second quarter of 2011 were $4.1 million and $6.5 million, respectively. Net charge-offs for the first quarter
of 2012 were $9.1 million, mainly from one real estate loan relationship. Most of the loan charge-offs in the second quarter of
2012 and the second quarter of 2011 were residential real estate and commercial loans. During the second quarter of 2011, we also
recorded large commercial real estate loan charge-offs. The allowance for credit losses as a percentage of average loans was 1.59%
for the second quarter of 2012, compared to 1.85% for the second quarter of 2011. Net charge-offs were $13.1 million and $9.7 million
for the first six months of 2012 and 2011, respectively. The allowance for credit losses as a percentage of average loans was 1.58%
for the first six months of 2012, compared to 1.85% for the same period in 2011. Management believes that the provision for credit
losses and the resulting allowance were adequate to provide for probable losses inherent in our loan portfolio at June 30, 2012.





33









The following table presents a summary
of the activity in the allowance for credit losses:



|                                                                                            |  | For the Three Months Ended |         |   | For the Six Months Ended |  
|------------------------------------------------------------------------------------------- |  | -------------------------- | ------- | - | ------------------------ | -
|                                                                                            |  | June 30,                   |         |   | June 30,                 |  
|(Dollars in thousands)                                                                      |  | 2012                       |         |   | 2011                     |  
|Allowance balance – beginning of period                                                     |  | $                          | 13,544  |   |                          | $
|Charge-offs:                                                                                |  |                            |         |   |                          |  
|Construction                                                                                |  |                            | (714    | ) |                          |  
|Residential real estate                                                                     |  |                            | (1,554  | ) |                          |  
|Commercial real estate                                                                      |  |                            | (745    | ) |                          |  
|Commercial                                                                                  |  |                            | (1,085  | ) |                          |  
|Consumer                                                                                    |  |                            | (162    | ) |                          |  
|Totals                                                                                      |  |                            | (4,260  | ) |                          |  
|Recoveries:                                                                                 |  |                            |         |   |                          |  
|Construction                                                                                |  |                            | -       |   |                          |  
|Residential real estate                                                                     |  |                            | 43      |   |                          |  
|Commercial real estate                                                                      |  |                            | -       |   |                          |  
|Commercial                                                                                  |  |                            | 133     |   |                          |  
|Consumer                                                                                    |  |                            | 5       |   |                          |  
|Totals                                                                                      |  |                            | 181     |   |                          |  
|Net charge-offs                                                                             |  |                            | (4,079  | ) |                          |  
|Provision for credit losses                                                                 |  |                            | 3,525   |   |                          |  
|Allowance balance – end of period                                                           |  | $                          | 12,990  |   |                          | $
|                                                                                            |  |                            |         |   |                          |  
|Average loans outstanding during the period                                                 |  | $                          | 816,553 |   |                          | $
|Net charge-offs (annualized) as a percentage of average loans outstanding during the period |  |                            | 2.01    | % |                          |  
|Allowance for credit losses at period end as a percentage of average loans                  |  |                            | 1.59    | % |                          |  





34









Nonperforming Assets

Nonperforming assets were $100.2 million
at June 30, 2012, compared to $88.7 million at December 31, 2011. The change in nonperforming assets
included a $9.4 million increase in nonperforming loans and a $2.1 million increase in other real estate owned.The increase
in nonperforming loans included a $12.0 million increase in accruing troubled debt restructurings net
of a $3.4 million decline in nonaccrual loans. The change in the components of nonperforming assets reflected our continued effort
to either develop concessionary workouts relating to problem loans or remove problem loans from our portfolio.See Note
8, “Fair Value Measurements”, in the Notes to Consolidated Financial Statements for additional details on the changes
in the balances of nonperforming assets. The ratio of total nonperforming assets to total loans and
other real estate owned was 12.20% at June 30, 2012, compared to 10.43% at December 31, 2011.Gross interest income of $1.5
million for the first six months of 2012, $2.6 million for fiscal year 2011 and $1.4 million for the first six months of 2011 would
have been recorded if nonaccrual loans had been current and performing in accordance with their original terms. No interest was
recorded on such loans for the first six months of 2012 or 2011.



The following table summarizes our nonperforming assets:



|                                                        |  | June 30, |         |  | December 31, |  
|------------------------------------------------------- |  | -------- | ------- |  | ------------ | -
|(Dollars in thousands)                                  |  | 2012     |         |  | 2011         |  
|Nonperforming assets                                    |  |          |         |  |              |  
|Nonaccrual loans                                        |  |          |         |  |              |  
|Construction                                            |  | $        | 14,258  |  |              | $
|Residential real estate                                 |  |          | 20,400  |  |              |  
|Commercial real estate                                  |  |          | 11,636  |  |              |  
|Commercial                                              |  |          | 1,609   |  |              |  
|Consumer                                                |  |          | 55      |  |              |  
|Total nonaccrual loans                                  |  |          | 47,958  |  |              |  
|                                                        |  |          |         |  |              |  
|Loans 90 days or more past due and still accruing       |  |          |         |  |              |  
|Construction                                            |  |          | -       |  |              |  
|Residential real estate                                 |  |          | 1,232   |  |              |  
|Commercial real estate                                  |  |          | 2,041   |  |              |  
|Commercial                                              |  |          | 62      |  |              |  
|Consumer                                                |  |          | 184     |  |              |  
|Total loans 90 days or more past due and still accruing |  |          | 3,519   |  |              |  
|                                                        |  |          |         |  |              |  
|Accruing troubled debt restructurings                   |  |          |         |  |              |  
|Construction                                            |  |          | 17,078  |  |              |  
|Residential real estate                                 |  |          | 5,008   |  |              |  
|Commercial real estate                                  |  |          | 15,077  |  |              |  
|Commercial                                              |  |          | 68      |  |              |  
|Consumer                                                |  |          | -       |  |              |  
|Total accruing troubled debt restructurings             |  |          | 37,231  |  |              |  
|Total nonperforming loans                               |  |          | 88,708  |  |              |  
|Other real estate owned                                 |  |          | 11,499  |  |              |  
|Total nonperforming assets                              |  | $        | 100,207 |  |              | $



|Nonaccrual loans to total loans                                 |  |  | 5.92  | % |  |  | 6.11  | %
|--------------------------------------------------------------- |  |  | ----- | - |  |  | ----- | -
|Nonaccrual loans to total assets                                |  |  | 4.08  | % |  |  | 4.44  | %
|Nonperforming assets to total loans and other real estate owned |  |  | 12.20 | % |  |  | 10.43 | %
|Nonperforming assets to total assets                            |  |  | 8.53  | % |  |  | 7.66  | %





35







Investment Securities

The investment portfolio is comprised of
securities that are either available for sale or held to maturity. Investment securities available for sale are stated at estimated
fair value based on quoted market prices. They represent securities which may be sold as part of the asset/liability management
strategy or which may be sold in response to changing interest rates. Net unrealized holding gains and losses on these securities
are reported net of related income taxes as accumulated other comprehensive income, a separate component of stockholders’
equity. Investment securities in the held to maturity category are stated at cost adjusted for amortization of premiums and accretion
of discounts. We have the intent and current ability to hold such securities until maturity. At June 30, 2012, 96% of the portfolio
was classified as available for sale and 4% as held to maturity, similar to the 95% and 5%, respectively, at December 31, 2011.
With the exception of municipal securities, our general practice is to classify all newly-purchased securities as available for
sale. See Note 3, “Investment Securities”, in the Notes to Consolidated Financial Statements for additional details
on the composition of our investment portfolio.



Investment securities totaled $138.4 million
at June 30, 2012, a $2.2 million, or 1.6%, increase since December 31, 2011. At the end of June 2012, 25.4% of the securities in
the portfolio were U.S. Government agencies and 70.4% were mortgage-backed securities, compared to 30.9% and 63.9% , respectively,
at year-end 2011, reflecting a shift in the composition of the portfolio to higher-yielding mortgage-backed securities. Our investments
in mortgage-backed securities are issued or guaranteed by U.S. Government agencies or government-sponsored agencies.



For the second quarter of 2012, the average
balance of investment securities increased to $134.3 million, compared to $111.2 million for the same period in 2011. For the first
six months of 2012, the average balance of investment securities increased to $134.2 million, compared to $108.7 million for the
same period in 2011. The increase in the 2012 investment securities average balances when compared to the 2011 balances reflected
the investment of excess cash from deposits. Investment securities comprised 12.4% of total average earning assets for the second
quarter of 2012, higher than the 10.5% for the second quarter of 2011. Similarly, for the first six months of 2012 and 2011, investment
securities were 12.3% and 10.3% of total earning assets, respectively. The tax equivalent yields on investment securities were
2.26% and 3.04% for the second quarter of 2012 and 2011, respectively, while the yields were 2.35%. and 2.89% for the first six
months of 2012 and 2011, respectively. Reinvestment rates on investment securities purchased during 2012 were lower than the yields
on the investment securities that matured during the period.



Deposits

Total deposits at June 30, 2012 were $1.033
billion, a $22.8 million, or 2.3%, increase when compared to the $1.010 billion at December 31, 2011. All deposit categories increased
from the end of 2011 except for interest-bearing demand deposits which decreased $14.8 million, or 9.2%, as deposits shifted to
money market and savings which increased $11.8 million, or 4.4%. Total time deposits increased $10.1 million, or 2.3%, primarily
due to liquidity in the market and the recent closure of a local competitor bank. Noninterest-bearing deposits increased $15.7
million, or 11.7%, which reflected continuing growth from our customer base.



Short-Term Borrowings

Short-term borrowings at June 30, 2012
and December 31, 2011 were $13.8 million and $17.8 million, respectively. Short-term borrowings generally consist of securities
sold under agreements to repurchase which are issued in conjunction with cash management services for commercial depositors, overnight
borrowings from correspondent banks and short-term advances from the Federal Home Loan Bank (the “FHLB”). Short-term
advances are defined as those with original maturities of one year or less. At June 30, 2012 and December 31, 2011, short-term
borrowings included only repurchase agreements.



Long-Term Debt

At June 30, 2012 and December 31, 2011,
the Company had $455 thousand in long-term debt. This debt was acquisition-related, incurred as part of the purchase price of TSGIA,
Inc. and is payable to the seller thereof, who remains the President of that subsidiary. The interest rate on the debt is 4.08%
and principal and interest are payable in annual installments for five years, with the final payment due on October 1, 2012.



Liquidity and Capital Resources

We derive liquidity through increased
customer deposits, maturities in the investment portfolio, loan repayments and income from earning assets. During the second quarter
of 2009, we began participating in the Promontory Insured Network Deposits Program which resulted in increased deposits and liquidity.
The program has a five-year term and has a guaranteed minimum funding level of $70 million.





36







To the extent that deposits are not adequate
to fund customer loan demand, liquidity needs can be met in the short-term funds markets through arrangements with correspondent
banks. The Banks had $15.5 million in unsecured federal funds lines of credit and a reverse repurchase agreement available on
a short-term basis from correspondent banks at June 30, 2012 and December 31, 2011. The Banks are also members of the FHLB, which
provides another source of liquidity. Through the FHLB, the Banks had credit availability of approximately $49.7 million and $31.6
million at June 30, 2012 and December 31, 2011, respectively. The Banks have pledged, under a blanket lien, all qualifying residential
loans under borrowing agreements with the FHLB. Management is not aware of any demands, commitments, events or uncertainties that
are likely to materially affect our future ability to maintain liquidity at satisfactory levels.



Total stockholders’ equity was $119.5
million at June 30, 2012, compared to $121.2 million at December 31, 2011. The net loss and dividends paid contributed to the decrease
in stockholders’ equity since the end of 2011. The decrease was partially offset by unrealized gains on available-for-sale
securities ($546 thousand) and cash flow hedging activities ($465 thousand) relating to the interest rate caps. To sustain capital
and enhance capital ratios, the board of directors of Shore Bancshares, Inc. decreased the quarterly
cash dividend on the common stock from $.06 per share to $0.01 per share beginning with the dividend that was paid on May 31, 2011.
On May 3, 2012, the board of directors voted to suspend quarterly cash dividends until further notice. If the dividend suspension
is continued, the Company will retain approximately $254 thousand in common equity for 2012. We remain
well-capitalized which enables us to fund the costs to resolve our problem loans.



Bank regulatory agencies have adopted various
capital standards for financial institutions, including risk-based capital standards. The primary objectives of the risk-based
capital framework are to provide a more consistent system for comparing capital positions of financial institutions and to take
into account the different risks among financial institutions’ assets and off-balance sheet items.



Risk-based capital standards have been
supplemented with requirements for a minimum Tier 1 capital to average assets ratio (leverage ratio). In addition, regulatory agencies
consider the published capital levels as minimum levels and may require a financial institution to maintain capital at higher levels.
The Company’s capital ratios continued to be well in excess of regulatory minimums.



The table below presents a comparison of
the Company’s capital ratios to the minimum regulatory requirements as of June 30, 2012 and December 31, 2011.



|                                |  |          |  |              |  | Minimum     
|------------------------------- |  | -------- |  | ------------ |  | ------------
|                                |  | June 30, |  | December 31, |  | Regulatory  
|                                |  | 2012     |  | 2011         |  | Requirements
|Tier 1 risk-based capital ratio |  | 12.61%   |  | 12.55%       |  | 4.00%       
|Total risk-based capital ratio  |  | 13.87%   |  | 13.80%       |  | 8.00%       
|Leverage ratio                  |  | 9.04%    |  | 9.29%        |  | 4.00%       



Item 3. Quantitative and Qualitative Disclosures about Market
Risk.



Our primary market risk is to interest
rate fluctuation and management has procedures in place to evaluate and mitigate this risk. This risk and these procedures are
discussed in Item 7 of Part II of the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2011
under the caption “Market Risk Management”. Management believes that there have been no material changes in our market
risks, the procedures used to evaluate and mitigate these risks, or our actual and simulated sensitivity positions since December
31, 2011.



Item 4. Controls and Procedures.



We maintain disclosure controls and procedures
that are designed to ensure that information required to be disclosed in the reports that Shore Bancshares, Inc. files under the
Securities Exchange Act of 1934 with the SEC, such as this Quarterly Report, is recorded, processed, summarized and reported within
the time periods specified in those rules and forms, and that such information is accumulated and communicated to management, including
Shore Bancshares, Inc.’s principal executive officer (“CEO”) and its principal accounting officer (“PAO”),
as appropriate, to allow for timely decisions regarding required disclosure. A control system, no matter how well conceived and
operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the
design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered
relative to their costs. These inherent limitations include the realities that judgments in decision-making can be faulty, and
that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts
of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls
also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design
will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because
of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.





37







An evaluation of the effectiveness of these
disclosure controls as of June 30, 2012 was carried out under the supervision and with the participation of management, including
the CEO and the PAO. Based on that evaluation, the Company’s management, including the CEO and the PAO, has concluded that
our disclosure controls and procedures are, in fact, effective at the reasonable assurance level.



There was no change in our internal control
over financial reporting during the second quarter of 2012 that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting.



PART II – OTHER
INFORMATION



Item 1A. Risk Factors.



The risks and uncertainties to which our
financial condition and operations are subject are discussed in detail in Item 1A of Part I of the Annual Report of Shore Bancshares,
Inc. on Form 10-K for the year ended December 31, 2011. Management does not believe that any material changes in our risk factors
have occurred since they were last disclosed.



Item 6. Exhibits.



The exhibits filed or
furnished with this quarterly report are shown on the Exhibit List that follows the signatures to this report, which list is incorporated
herein by reference.



SIGNATURES



Pursuant to the requirements 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.





|                     | SHORE BANCSHARES, INC.
|-------------------- | ----------------------
|                     |                       
|                     |                       
|                     |                       
|Date: August 9, 2012 | By:                   
|                     |                       





|                     |    
|-------------------- | ---
|Date: August 9, 2012 | By:
|                     |    





38









EXHIBIT INDEX





|Exhibit |                                                                                                     
|------- | ----------------------------------------------------------------------------------------------------
|Number  | Description                                                                                         
|        |                                                                                                     
|31.1    | Certifications of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act 
|        | (filed herewith).                                                                                   
|        |                                                                                                     
|31.2    | Certifications of the Principal Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley Act
|        | (filed herewith).                                                                                   
|        |                                                                                                     
|32      | Certification pursuant to Section 906 of the Sarbanes-Oxley Act (furnished herewith).               
|        |                                                                                                     
|101.INS | XBRL Instance File (furnished herewith).                                                            
|        |                                                                                                     
|101.SCH | XBRL Label File (furnished herewith).                                                               
|        |                                                                                                     
|101.CAL | XBRL Calculation File (furnished herewith).                                                         
|        |                                                                                                     
|101.DEF | XBRL Definition File (furnished herewith).                                                          
|        |                                                                                                     
|101.LAB | XBRL Label File (furnished herewith).                                                               
|        |                                                                                                     
|101.PRE | XBRL Presentation File (furnished herewith).                                                        







39