UNITED
STATES  SECURITIES AND EXCHANGE COMMISSION
 Washington,
D.C.  20549
 
 
 FORM 10-K
 
 x
              ANNUAL
      REPORT UNDER SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
 
 For the
fiscal year ended December 31, 2008
 
 Or
 
  ̈
              TRANSITION
      REPORT UNDER SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
 
 For the
transition period from _____________ to ________________
 
 Commission
file Number:  2-88927
 
 FIRST KEYSTONE
CORPORATION
 (Exact name of registrant as specified
in its Charter)
 
 Pennsylvania
                23-2249083(State
      or other jurisdiction of incorporation or organization)
                (I.R.S.
      Employer Identification Number)111
      West Front Street, Berwick, Pennsylvania
                18603(Address
      of principal executive offices)
                (Zip
      Code)
 
 Registrant's
telephone number, including area code:  (570) 752-3671
 
 Securities
registered pursuant to Section 12(b) of the Act:  None
 
 Securities
registered pursuant to Section 12(g) of the Act:  Common Stock, par value $2.00 per
share
 
 Indicate
by check mark if the registrant is a well-known seasoned issuer as defined in
Rule 405 of the Securities Act.
 Yes  ̈        No
x
 
 Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Exchange Act.
 Yes  ̈        No
x
 
 Indicate
by check mark whether the Registrant (1) filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12
months (or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days.      Yes x       No
 ̈
 
 Indicate
by check mark if there is no disclosure of delinquent filers in response to Item
405 of Regulation S-K contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K.    Yes  ̈       No
x
 
 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
definitions of “large accelerated filer,” “accelerated filer,” and “small
reporting company” in Rule 12b-2 of the Exchange
Act.          Large
accelerated filer  ̈             Accelerated
filer  x            Non-accelerated
filer  ̈
 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
 
 The
aggregate market value of the registrant’s outstanding voting common stock held
by non-affiliates on June 30, 2008 determined by using a per share closing price
on that date of $15.50, as quoted on The Over The Counter Bulletin Board, was
$73,541,858.
 
 At March
9, 2009, there were 5,440,126 shares of Common Stock, $2.00 par value,
outstanding.
 
 DOCUMENTS
INCORPORATED BY REFERENCE
 Portions
of the Registrant's 2009 definitive Proxy Statement are incorporated by
reference in Part III of this Report.
  
  FIRST
KEYSTONE CORPORATION
 FORM
10-K
 
 Table of
Contents
 
 Part I
                        
                        PageItem
      1.
                        Business
                        1Item
      1A.
                        Risk
      Factors
                        8Item
      1B.
                        Unresolved
      Staff Comments
                        10Item
      2.
                        Description
      of Properties
                        10Item
      3.
                        Legal
      Proceedings
                        11Item
      4.
                        Submission
      of Matters to a Vote of Security Holders
                        11Part
      IIItem
      5.
                        Market
      for Registrant's Common Equity and Related Shareholder Matters and Issuer
      Purchases of Equity Securities
                        11Item
      6.
                        Selected
      Financial Data
                        14Item
      7.
                        Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
                        15Item
      7A.
                        Quantitative
      and Qualitative Disclosure About Market Risk
                        29Item
      8.
                        Financial
      Statements and Supplementary Data
                        30Item
      9.
                        Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                        69Item
      9A.
                        Controls
      and Procedures
                        69Item
      9B.
                        Other
      Information
                        69Part
      IIIItem
      10.
                        Directors,
      Executive Officers and Corporate Governance
                        70Item
      11.
                        Executive
      Compensation
                        70Item
      12.
                        Security
      Ownership of Certain Beneficial Owners and Management and Related
      Shareholder Matters
                        70Item
      13.
                        Certain
      Relationships and Related Transactions, and Director
      Independence
                        70Item
      14.
                        Principal
      Accountant Fees and Services
                        70Part
      IVItem
      15.
                        Exhibits
      and Financial Statement Schedules
                        71Signatures
                        73Exhibit
      21Exhibit
      23Exhibit
      31.1Exhibit
      31.2Exhibit
      32.1Exhibit
      32.2
  ii
  FIRST
KEYSTONE CORPORATION
 FORM
10-K
 
 PART
I
 
 Forward Looking
Statements
 
 The
management of First Keystone Corporation (Corporation), has made forward-looking
statements in this annual report on Form 10-K.  These forward-looking
statements may be subject to risks and uncertainties.  Forward-looking
statements include the information concerning possible or assumed future results
of operations of the Corporation and its subsidiary, First Keystone National
Bank (Bank).  When words such as “believes,” “expects,” “anticipates”
or similar expressions occur in this annual report, management is making
forward-looking statements.
 
 Shareholders
should note that many factors, some of which are discussed elsewhere in this
annual report, could affect the future financial results of the Corporation and
its subsidiary, both individually and collectively, and could cause those
results to differ materially from those expressed in the forward-looking
statements contained in this annual report on Form 10-K.  These
factors include the following:
 
 ·
                operating,
      legal and regulatory risks;
 ·
              economic,
      political and competitive forces affecting our banking, securities, asset
      management and credit services businesses;
and
 ·
              the
      risk that our analyses of these risks and forces could be incorrect and or
      that the strategies developed to address them could be
      unsuccessful.
 
 The
Corporation undertakes no obligation to publicly revise or update these
forward-looking statements to reflect events or circumstances that arise after
the date of this report.  Readers should carefully review the risk
factors described in other documents that are filed periodically with the
Securities and Exchange Commission (SEC).
  ITEM
1.       BUSINESS
 
 First
Keystone Corporation is a Pennsylvania business corporation, and a bank holding
company, registered with and supervised by the Board of Governors of the Federal
Reserve System.  The Corporation was incorporated on July 6,
1983, and commenced operations on July 2, 1984, upon consummation of the
acquisition of all of the outstanding stock of First Keystone National
Bank.  The Corporation has one wholly-owned subsidiary, the Bank,
which has a commercial banking operation and trust department as its major lines
of business.  Since commencing operations, the Corporation's business
has consisted primarily of managing and supervising the Bank, and its principal
source of income has been dividends paid by the Bank.  Greater than
98% of the company's revenue and profit came from the commercial banking
department for the years ended December 31, 2008, 2007, and 2006, and was the
only reportable segment.  At December 31, 2008, the Corporation
had total consolidated assets, deposits and stockholders' equity of
approximately $715 million, $505 million and $69 million,
respectively.
 
 The Bank
was organized in 1864.  The Bank is a national banking association
that is a member of the Federal Reserve System.  Its deposits are
insured by the Federal Deposit Insurance Corporation (FDIC) to the maximum
extent of the law regulated by The Office of the Comptroller of the Currency
(OCC).  The Bank, has fourteen branch locations (five branches within
Columbia County, four branches within Luzerne County, one branch in Montour
County, and four branches within Monroe County, Pennsylvania), and is a full
service commercial bank providing a wide range of services to individuals and
small to medium sized businesses in its Northeastern and Central Pennsylvania
market area.  The Bank's commercial banking activities include
accepting time, demand, and savings deposits and making secured and unsecured
commercial, real estate and consumer loans.  Additionally, the Bank
also provides personal and corporate trust and agency services to individuals,
corporations, and others, including trust investment accounts, investment
advisory services, mutual funds, estate planning, and management of pension and
profit sharing plans.
  1
  Acquisition
 
 Effective
November 1, 2007, the Corporation completed its acquisition of Pocono Community
Bank through the merger of Pocono with and into the Bank.  On the
acquisition date, Pocono Community Bank had approximately $150 million in
assets, $105 million in loans and $110 million in
deposits.  Headquartered in Stroudsburg, Pennsylvania and organized in
1996, Pocono had 4 banking offices located in Montour County,
Pennsylvania.  The acquisition expands the branch network of the
Corporation and provides Pocono customers with a broader array of products and
services.  The Pocono branches continue to operate as a division of
the Bank under the name “Pocono Community Bank, a division of First Keystone
National Bank.”
 
 Supervision and
Regulation
 
 The
Corporation is subject to the jurisdiction of the SEC and of state securities
laws for matters relating to the offering and sale of its
securities.  The Corporation is currently subject to the SEC's rules
and regulations relating to company's whose shares are registered under Section
12 of the Securities Exchange Act of 1934, as amended.
 
 The
Corporation is also subject to the provisions of the Bank Holding Company Act of
1956, as amended , and to supervision by the Federal Reserve
Board.  The Bank Holding Company Act requires the Corporation to
secure the prior approval of the Federal Reserve Board before it owns or
controls, directly or indirectly, more than 5% of the voting shares of
substantially all of the assets of any institution, including another
bank.
 
 The Bank
Holding Company Act also prohibits acquisition of control of a bank holding
company, such as the Corporation, without prior notice to the Federal Reserve
Board.  Control is defined for this purpose as the power, directly or
indirectly, to direct the management or policies of a bank holding company or to
vote 25% (or 10%, if no other person or persons acting on concert, holds a
greater percentage of the Common Stock) or more of the Corporation's Common
Stock.
 
 The
Corporation is required to file an annual report with the Federal Reserve Board
and any additional information that the Federal Reserve Board may require
pursuant to the Bank Holding Company Act.  The Federal Reserve Board
may also make examinations of the Corporation and any or all of its
subsidiaries.
 
 The Bank
is subject to federal and state statutes applicable to banks chartered under the
banking laws of the United States, to members of the Federal Reserve System and
to banks whose deposits are insured by the FDIC.  Bank operations are
also subject to regulations of the OCC, the Federal Reserve Board and the
FDIC.
 
 The
primary supervisory authority of the Bank is the OCC, which regulates and
examines the Bank.  The OCC has the authority under the Financial
Institutions Supervisory Act to prevent a national bank from engaging in an
unsafe or unsound practice in conducting its business.
 
 Federal
and state banking laws and regulations govern, among other things, the scope of
a bank's business, the investments a bank may make, the reserves against
deposits a bank must maintain, loans a bank makes and collateral it takes, and
the activities of a bank with respect to mergers and consolidations and the
establishment of branches.
 
 As a
subsidiary of a bank holding company, the Bank is subject to certain
restrictions imposed by the Federal Reserve Act on any extensions of credit to
the bank holding company or its subsidiaries, on investments in the stock or
other securities of the bank holding company or its subsidiaries and on taking
such stock or securities as collateral for loans.  The Federal Reserve
Act and Federal Reserve Board regulations also place certain limitations and
reporting requirements on extensions of credit by a bank to principal
shareholders of its parent holding company, among others, and to related
interests of such principal shareholders.  In addition, such
legislation and regulations may affect the terms upon which any person becoming
a principal shareholder of a holding company may obtain credit from banks with
which the subsidiary bank maintains a correspondent relationship.
 
 Under the
Federal Deposit Insurance Act , the OCC possesses the power to prohibit
institutions regulated by it from engaging in any activity that would be an
unsafe or unsound banking practice or would otherwise be in violation of the
law.
  2
  Permitted Non-Banking
Activities
 
 The
Federal Reserve Board permits bank holding companies to engage in non-banking
activities so closely related to banking, managing or controlling banks as to be
a proper incident thereto.  The Corporation does not at this time
engage in any of these non-banking activities, nor does the Corporation have any
current plans to engage in any other permissible activities in the foreseeable
future.
 
 Legislation and Regulatory
Changes
 
 From time
to time, various types of federal and state legislation have been proposed that
could result in additional regulations of, and restrictions on, the business of
the Bank.  It cannot be predicted whether any such legislation will be
adopted or how such legislation would affect the business of the
Bank.  As a consequence of the extensive regulation of commercial
banking activities in the United States, the Bank's business is particularly
susceptible to being affected by federal legislation and regulations that may
increase the costs of doing business.
 
 From time
to time, legislation is enacted which has the effect of increasing the cost of
doing business, limiting or expanding permissible activities or affecting the
competitive balance between banks and other financial
institutions.  No prediction can be made as to the likelihood of any
major changes or the impact such changes might have on the Corporation and the
Bank.  Certain changes of potential significance to the Corporation
which have been enacted recently and others which are currently under
consideration by Congress or various regulatory agencies are discussed
below.
 
 Federal Deposit Insurance
Corporation Improvement Act of 1991
 
 The
FDICIA established five different levels of capitalization of financial
institutions, with “prompt corrective actions” and significant operational
restrictions imposed of institutions that are capital deficient under the
categories.  The five categories are:
 
 ·  well
capitalized
 ·  adequately
capitalized
 ·  undercapitalized
 ·  significantly
undercapitalized, and
 ·  critically
undercapitalized.
 
 To be
considered well capitalized, an institution must have a total risk-based capital
ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6%, a
leverage capital ratio of at least 5%, and must not be subject to any order or
directive requiring the institution to improve its capital level.  An
institution falls within the adequately capitalized category if it has a total
risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at
least 4%, and a leverage capital ratio of at least 4%.  Institutions
with lower capital levels are deemed to be undercapitalized, significantly
undercapitalized or critically undercapitalized, depending on their actual
capital levels.  In addition, the appropriate federal regulatory
agency may downgrade an institution to the next lower capital category upon a
determination that the institution is in an unsafe or unsound condition, or is
engaged in an unsafe or unsound practice.  Institutions are required
under FDICIA to closely monitor their capital levels and to notify their
appropriate regulatory agency of any basis for a change in capital
category.  On December 31, 2008 the Corporation and the Bank exceeded
the minimum capital levels of the well capitalized category.
 
 Regulatory
oversight of an institution becomes more stringent with each lower capital
category, with certain “prompt corrective actions” imposed depending on the
level of capital deficiency.
  3
  Other Provisions of
FDICIA
 
 Each
depository institution must submit audited financial statements to its primary
regulator and the FDIC, which reports are made publicly available.  In
addition, the audit committee of each depository institution must consist of
outside directors and the audit committee at “large institutions” (as defined by
FDIC regulation) must include members with banking or financial management
expertise.  The audit committee at “large institutions” must also have
access to independent outside counsel.  In addition, an institution
must notify the FDIC and the institution's primary regulator of any change in
the institutions independent auditor, and annual management letters must be
provided to the FDIC and the depository institution's primary
regulator.  The regulations define a “large institution” as one with
over $500 million in assets, which does include the Bank.  Also, under
the rule, an institution's independent auditor must examine the institution's
internal controls over financial reporting and perform agreed-upon procedures to
test compliance with laws and regulations concerning safety and
soundness.
 
 Under
FDICIA, each federal banking agency must prescribe certain safety and soundness
standards for depository institutions and their holding
companies.  Three types of standards must be prescribed:
 
 ·  asset
quality and earnings
 ·  operational
and managerial, and
 ·  compensation
 
 Such
standards would include a ratio of classified assets to capital, minimum
earnings, and, to the extent feasible, a minimum ratio of market value to book
value for publicly traded securities of such institutions and holding
companies.  Operational and managerial standards must relate
to:
 
 ·  internal
controls, information systems and internal audit systems
 ·  loan
documentation
 ·  credit
underwriting
 ·  interest
rate exposure
 ·  asset
growth, and
 ·  compensation,
fees and benefits
 
 FDICIA
also sets forth Truth in Savings disclosure and advertising requirements
applicable to all depository institutions.
 
 Real Estate Lending
Standards.  Pursuant to the FDICIA, the OCC and other federal
banking agencies adopted real estate lending guidelines which would set
loan-to-value ratios for different types of real estate loans.  A LTV
ratio is generally defined as the total loan amount divided by the appraised
value of the property at the time the loan is originated.  If the
institution does not hold a first lien position, the total loan amount would be
combined with the amount of all senior liens when calculating the
ratio.  In addition to establishing the LTV ratios, the guidelines
require all real estate loans to be based upon proper loan documentation and a
recent appraisal of the property.
 
 Regulatory Capital
Requirements
 
 The
federal banking regulators have adopted certain risk-based capital guidelines to
assist in the assessment of the capital adequacy of a banking organization's
operations for both transactions reported on the balance sheet as assets and
transactions, such as letters of credit, and recourse agreements, which are
recorded as off balance sheet items.  Under these guidelines, nominal
dollar amounts of assets and credit equivalent amounts of off balance sheet
items are multiplied by one of several risk adjustment percentages, which range
from 0% for assets with low credit risk, such as certain U.S. Treasury
securities, to 100% for assets with relatively high credit risk, such as
business loans.
  4
  The
following table presents the Corporation's capital ratios at December 31,
2008.
 
 (In Thousands)Tier
      I Capital
                          
                          $
                          52,738Tier
      II Capital
                          
                          
                          5,195Total
      Capital
                          
                          $
                          57,933Adjusted
      Total Average Assets
                          
                          
                          716,058Total
      Adjusted Risk-Weighted Assets1
                          
                          
                          481,798Tier
      I Risk-Based Capital Ratio2
                          
                          
                          10.95
                          %Required
      Tier I Risk-Based Capital Ratio
                          
                          
                          4.00
                          %Excess
      Tier I Risk-Based Capital Ratio
                          
                          
                          6.95
                          %Total
      Risk-Based Capital Ratio3
                          
                          
                          12.02
                          %Required
      Total Risk-Based Capital Ratio
                          
                          
                          8.00
                          %Excess
      Total Risk-Based Capital Ratio
                          
                          
                          4.02
                          %Tier
      I Leverage Ratio4
                          
                          
                          7.59
                          %Required
      Tier I Leverage Ratio
                          
                          
                          4.00
                          %Excess
      Tier I Leverage Ratio
                          
                          
                          3.59
                          %
  
 1Includes off-balance sheet items at
credit-equivalent values less intangible assets.
 2Tier I Risk-Based Capital Ratio is
defined as the ratio of Tier I Capital to Total Adjusted Risk-Weighted
Assets.
 3Total Risk-Based Capital Ratio is
defined as the ratio of Tier I and Tier II Capital to Total Adjusted
Risk-Weighted Assets.
 4Tier I Leverage Ratio is defined as the
ratio of Tier I Capital to Adjusted Total Average Assets.
 
 The
Corporation's ability to maintain the required levels of capital is
substantially dependent upon the success of Corporation's capital and business
plans; the impact of future economic events on the Corporation's loan customers;
and the Corporation's ability to manage its interest rate risk and investment
portfolio and control its growth and other operating expenses.  See
also, the information under the caption “Capital Strength” appearing on page 25
of this 2008 Annual Report on Form 10-K.
 
 Effect of Government
Monetary Policies
 
 The
earnings of the Corporation are and will be affected by domestic economic
conditions and the monetary and fiscal policies of the United States government
and its agencies.
 
 The
Federal Reserve Board have had, and will likely continue to have, an important
impact on the operating results of commercial banks through its power to
implement national monetary policy in order to, among other things, curb
inflation or combat a recession.  The Federal Reserve Board has a
major effect upon the levels of bank loans, investments and deposits through its
open market operations in United States government securities and through its
regulations of, among other things, the discount rate on borrowings of member
banks and the reserve requirements against member bank deposits.  It
is not possible to predict the nature and impact of future changes in monetary
and fiscal policies.
 
 Effects of
Inflation
 
 Inflation
has some impact on the Bank's operating costs.  Unlike industrial
companies, however, substantially all of the Bank's assets and liabilities are
monetary in nature.  As a result, interest rates have a more
significant impact on the Bank's performance than the general levels of
inflation.  Over short periods of time, interest rates may not
necessarily move in the same direction or in the same magnitude as prices of
goods and services.
 
 Environmental
Regulation
 
 There are
several federal and state statutes that regulate the obligations and liabilities
of financial institutions pertaining to environmental issues.  In
addition to the potential for attachment of liability resulting from its own
actions, a bank may be held liable, under certain circumstances, for the actions
of its borrowers, or third parties, when such actions result in environmental
problems on properties that collateralize loans held by the
bank.  Further, the liability has the potential to far exceed the
original amount of the loan issued by the Bank.  Currently, neither
the Corporation nor the Bank is a party to any pending legal proceeding pursuant
to any environmental statute, nor are the Corporation and the Bank aware of any
circumstances that may give rise to liability under any such
statute.
  5
  Interest Rate
Risk
 
 Federal
banking agency regulations specify that the Bank's capital adequacy include an
assessment of the Bank's interest rate risk  exposure.  The
standards for measuring the adequacy and effectiveness of a banking
organization's Interest Rate Risk (IRR) management includes a measurement of
Board of Directors and senior management oversight, and a determination of
whether a banking organization's procedures for comprehensive risk management
are appropriate to the circumstances of the specific banking
organization.  First Keystone National Bank has internal IRR models
that are used to measure and monitor IRR.  Additionally, the
regulatory agencies have been assessing IRR on an informal basis for several
years.  For these reasons, the Corporation does not expect the
addition of IRR evaluation to the agencies' capital guidelines to result in
significant changes in capital requirements for the Bank.
 
 The Gramm-Leach-Bliley Act
of 2000
 
 In 2000,
the Gramm-Leach-Bliley Act became law, which is also known as the Financial
Services Modernization Act.  The act repealed some Depression-era
banking laws and will permit banks, insurance companies and securities firms to
engage in each others' businesses after complying with certain conditions and
regulations.  The act grants to community banks the power to enter new
financial markets as a matter of right that larger institutions have managed to
do on an ad hoc basis.  At this time, our company has no plans to
pursue these additional possibilities.
 
 The Sarbanes-Oxley
Act
 
 In 2002,
the Sarbanes-Oxley Act became law.  The Act was in response to public
concerns regarding corporate accountability in connection with recent high
visibility accounting scandals.  The stated goals of the
Sarbanes-Oxley Act are:
 
 ·
              to
      increase corporate responsibility;
 ·
              to
      provide for enhanced penalties for accounting and auditing improprieties
      at publicly traded companies; and
 ·
              to
      protect investors by improving the accuracy and reliability of corporate
      disclosures pursuant to the securities
laws.
 
 The
Sarbanes-Oxley Act generally applies to all companies, both U.S. and non-U.S.,
that file periodic reports with the SEC under the Securities Exchange Act of
1934.  The legislation includes provisions, among other
things:
 
 ·
              governing
      the services that can be provided by a public company’s independent
      auditors and the procedures for approving such
  services;
 ·
              requiring
      the chief executive officer and chief financial officer to certify certain
      matters relating to the company’s periodic filings under the Exchange
      Act;
 ·
              requiring
      expedited filings of reports by insiders of their securities transactions
      and containing other provisions relating to insider conflicts of
      interest;
 ·
              increasing
      disclosure requirements relating to critical financial accounting policies
      and their application;
 ·
              increasing
      penalties for securities law violations;
and
 ·
              creating
      a public accounting oversight board, a regulatory body subject to SEC
      jurisdiction with broad powers to set auditing, quality control and ethics
      standards for accounting firms.
 
 The American Jobs Creation
Act of 2004
 
 In 2004,
the American Jobs Creation Act was enacted as the first major corporation tax
act in years.  The act addresses a number of areas of corporate
taxation including executive deferred compensation restrictions.  The
impact of the act on the Corporation is unknown at this time, but management is
monitoring its developments.
 
 History and Business -
Bank
 
 The
Bank's legal headquarters are located at 111 West Front Street, Berwick,
Pennsylvania.
 
 As of
December 31, 2008, the Bank had total assets of $714,898,000, total
shareholders' equity of $69,147,000 and total deposits and other liabilities of
$645,751,000.
  6
  The Bank
engages in a full-service commercial banking business, including accepting time
and demand deposits, and making secured and unsecured commercial and consumer
loans.  The Bank's business is not seasonal in nature.  Its
deposits are insured by the FDIC to the extent provided by law.  The
Bank has no foreign loans or highly leveraged transaction loans, as defined by
the Federal Reserve Board.  Substantially all of the loans in the
Bank’s portfolio have been originated by the Bank.  Policies adopted
by the Board of Directors are the basis by which the Bank conducts its lending
activities.
 
 At
December 31, 2008, the Bank had 146 full-time employees and 35 part-time
employees.  In the opinion of management, the Bank enjoys a
satisfactory relationship with its employees.  The Bank is not a party
to any collective bargaining agreement.
 
 Competition -
Bank
 
 The Bank
competes actively with other area commercial banks and savings and loan
associations, many of which are larger than the Bank, as well as with major
regional banking and financial institutions.  The Bank's major
competitors in Columbia, Luzerne, Montour, and Monroe counties are:
 
 ·    First
Columbia Bank & Trust Co. of Bloomsburg
 ·    PNC
Bank, N.A.
 ·    M
& T Bank
 ·    FNB
Bank, NA
 ·    Wachovia
Bank
 ·    Sovereign
Bank
 ·    Citizens
Bank
 ·    ESSA
Bank & Trust
 ·    First
National Community Bank
 ·    North
Penn Bank
 ·    Wayne
Bank
 
 Credit
unions are also competitors, especially in Luzerne and Montour
counties.  The Bank is generally competitive with all competing
financial institutions in its service area with respect to interest rates paid
on time and savings deposits, service charges on deposit accounts and interest
rates charged on loans.
 
 Concentration
 
 The
Corporation and the Bank are not dependent for deposits nor exposed by loan
concentrations to a single customer or to a small group of customers the loss of
any one or more of whom would have a materially adverse effect on the financial
condition of the Corporation or the Bank.
 
 Available
Information
 
 The
Corporation’s common stock is registered under Section 12(b) of the Securities
Exchange Act of 1934.  The Corporation is subject to the informational
requirements of the Exchange Act, and, accordingly, files reports, proxy
statements and other information with the Securities and Exchange
Commission.  The reports, proxy statements and other information filed
with the SEC are available for inspection and copying at the SEC’s Public
Reference Room at Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C.
20549.  You may obtain information on the operation of the Public
Reference Room by calling the SEC at 1-800-SEC-0330.  The
Corporation is an electronic filer with the SEC.  The SEC maintains an
Internet site that contains reports, proxy and information statements, and other
information regarding issuers that file electronically with the
SEC.  The SEC’s internet site address is www.sec.gov.
 
 A copy of
the Corporation’s Annual Report on Form 10-K may be obtained without charge at
www.fkyscorp.com or via email at info@fknbank.com.  Information may
also be obtained via written request to Investor Relations at First Keystone
Corporation, Attention: Cheryl Wynings, 111 West Front Street, P.O. Box 289,
Berwick, Pennsylvania 18603.
  7
  ITEM
1A.     RISK FACTORS
 
 Investments
in First Keystone Corporation common stock involve risk.  The market
price of First Keystone common stock may fluctuate significantly in response to
a number of factors, including:
 
 The
Corporation Is Subject To Interest Rate Risk
 
 The
Corporation’s earnings and cash flows are largely dependent upon its net
interest income.  Net interest income is the difference between
interest income earned on interest-earning assets such as loans and securities
and interest expense paid on interest-bearing liabilities such as deposits and
borrowed funds.  Interest rates are highly sensitive to many factors
that are beyond the Corporation’s control, including general economic conditions
and policies of various governmental and regulatory agencies and, in particular,
the Board of Governors of the Federal Reserve System.  Changes in
monetary policy, including changes in interest rates, could influence not only
the interest the Corporation receives on loans and securities and the amount of
interest it pays on deposits and borrowings, but such changes could also affect
(I) the Corporation’s ability to originate loans and obtain deposits,
(ii) the fair value of the Corporation’s financial assets and liabilities,
and (iii) the average duration of the Corporation’s mortgage-backed
securities portfolio.  If the interest rates paid on deposits and
other borrowings increase at a faster rate than the interest rates received on
loans and other investments, the Corporation’s net interest income, and
therefore earnings, could be adversely affected.  Earnings could also
be adversely affected if the interest rates received on loans and other
investments fall more quickly than the interest rates paid on deposits and other
borrowings.
 
 Although
management believes it has implemented effective asset and liability management
strategies, to reduce the potential effects of changes in interest rates on the
Corporation’s results of operations, any substantial, unexpected, prolonged
change in market interest rates could have a material adverse effect on the
Corporation’s financial condition and results of operations.
 
 The
Corporation’s Profitability Depends Significantly On Economic Conditions In The
Commonwealth of Pennsylvania
 
 The
Corporation’s success depends primarily on the general economic conditions of
the Commonwealth of Pennsylvania and the specific local markets in which the
Corporation operates.  Unlike larger national or other regional banks
that are more geographically diversified, the Corporation provides banking and
financial services to customers primarily in the Columbia, Luzerne, Montour, and
Monroe Counties.  The local economic conditions in these areas have a
significant impact on the demand for the Corporation’s products and services as
well as the ability of the Corporation’s customers to repay loans, the value of
the collateral securing loans and the stability of the Corporation’s deposit
funding sources.  Also a significant decline in general economic
conditions could impact the local economic conditions and, in turn, have a
material adverse effect on the Corporation’s financial condition and results of
operations.
 
 The
Corporation Operates In A Highly Competitive Industry
 
 The
Corporation faces substantial competition in all areas of its operations from a
variety of different competitors, many of which are larger and may have more
financial resources.  Such competitors primarily include national,
regional, and community banks within the various markets the Corporation
operates.  Additionally, various out-of-state banks have begun to
enter or have announced plans to enter the market areas in which the Corporation
currently operates.  The Corporation also faces competition from many
other types of financial institutions, including, without limitation, savings
and loans, credit unions, finance companies, brokerage firms, insurance
companies, factoring companies and other financial
intermediaries.  Also, technology has lowered barriers to entry and
made it possible for non-banks to offer products and services traditionally
provided by banks, such as automatic transfer and automatic payment
systems.  Many of the Corporation’s competitors have fewer regulatory
constraints and may have lower cost structures.
 
 The
Corporation’s ability to compete successfully depends on a number of factors,
including, among other things:
 
 ·
              The
      ability to develop, maintain and build upon long-term customer
      relationships based on top quality service, high ethical standards and
      safe, sound assets.
 ·
              The
      ability to expand the Corporation’s market
  position.
 ·
              The
      scope, relevance and pricing of products and services offered to meet
      customer needs and demands.
 ·
              The
      rate at which the Corporation introduces new products and services
      relative to its competitors.
 ·
              Customer
      satisfaction with the Corporation’s level of
  service.
 ·
              Industry
      and general economic trends.
  8
  Failure
to perform in any of these areas could significantly weaken the Corporation’s
competitive position, which could adversely affect the Corporation’s growth and
profitability, which, in turn, could have a material adverse effect on the
Corporation’s financial condition and results of operations.
 
 The
Corporation Is Subject To Extensive Government Regulation and
Supervision
 
 The
Corporation, primarily through the Bank, is subject to extensive federal and
state regulation and supervision. Banking regulations are primarily intended to
protect depositors’ funds, federal deposit insurance funds and the banking
system as a whole, not shareholders. These regulations affect the Corporation’s
lending practices, capital structure, investment practices, dividend policy and
growth, among other things. Congress and federal regulatory agencies continually
review banking laws, regulations and policies for possible changes. Changes to
statutes, regulations or regulatory policies could affect the Corporation in
substantial and unpredictable ways. Such changes could subject the Corporation
to additional costs, limit the types of financial services and products the
Corporation may offer and/or increase the ability of non-banks to offer
competing financial services and products, among other things. Failure to comply
with laws, regulations or policies could result in sanctions by regulatory
agencies, civil money penalties and/or reputation damage, which could have a
material adverse effect on the Corporation’s business, financial condition and
results of operations.
 
 The
Corporation Is Subject To Claims and Litigation Pertaining To Fiduciary
Responsibility
 
 From time
to time, customers make claims and take legal action pertaining to the
Corporation’s performance of its fiduciary responsibilities. Whether customer
claims and legal action related to the Corporation’s performance of its
fiduciary responsibilities are founded or unfounded, if such claims and legal
actions are not resolved in a manner favorable to the Corporation they may
result in significant financial liability and/or adversely affect the market
perception of the Corporation and its products and services as well as impact
customer demand for those products and services. Any financial liability or
reputation damage could have a material adverse effect on the Corporation’s
financial condition and results of operations.
 
 The
Trading Volume In The Corporation’s Common Stock Is Less Than That Of Other
Larger Financial Services Companies
 
 The
Corporation’s common stock is currently not listed but traded on the Over The
Counter Bulletin Board.  As a result, trading volume is less than that
of other larger financial services companies.  A public trading market
having the desired characteristics of depth, liquidity and orderliness depends
on the presence in the marketplace of willing buyers and sellers of the
Corporation’s common stock at any given time.  This presence depends
on the individual decisions of investors and general economic and market
conditions over which the Corporation has no control.  Given the lower
trading volume of the Corporation’s common stock, significant sales of the
Corporation’s common stock, or the expectation of these sales, could cause the
Corporation’s stock price to fall.
 
 The
Corporation Is Subject To Lending Risk
 
 As of
December 31, 2008, approximately 58.6% of the Corporation’s loan portfolio
consisted of commercial and industrial, construction and commercial real estate
loans.  These types of loans are generally viewed as having more risk
of default than residential real estate loans or consumer
loans.  These types of loans are also typically larger than
residential real estate loans and consumer loans.  Because the
Corporation’s loan portfolio contains a significant number of commercial and
industrial, construction and commercial real estate loans with relatively large
balances, the deterioration of one or a few of these loans could cause a
significant increase in non-performing loans.  An increase in
non-performing loans could result in a net loss of earnings from these loans, an
increase in the provision for possible loan losses and an increase in loan
charge-offs, all of which could have a material adverse effect on the
Corporation’s financial condition and results of operations.
 
 If
The Corporation’s Allowance For Loan Losses Is Not Sufficient To Cover Actual
Loan Losses, Its Earnings Could Decrease
 
 The
Corporation’s loan customers may not repay their loans according to the terms of
their loans, and the collateral securing the payment of their loans may be
insufficient to assure repayment.  The Corporation may experience
significant credit losses, which could have a material adverse effect on its
operating results.  In determining the amount of the allowance for
loan losses, the Corporation reviews its loans and its loss and delinquency
experience, and the Corporation evaluates economic conditions.  If its
assumptions prove to be incorrect, its allowance for loan losses may not cover
inherent losses in its loan portfolio at the date of its financial
statements.  Material additions to the Corporation’s allowance would
materially decrease its net income. At December 31, 2008, its allowance for loan
losses totaled $5.2 million, representing 1.33% of its average total
loans.
  9
  Although
the Corporation believes it has underwriting standards to manage normal lending
risks, it is difficult to assess the future performance of its loan portfolio
due to the relatively recent origination of many of these loans.  The
Corporation cannot assure that its non-performing loans will not increase or
that its non-performing or delinquent loans will not adversely affect its future
performance.
 
 In
addition, federal and state regulators periodically review the Corporation’s
allowance for loan losses and may require it to increase its allowance for loan
losses or recognize further loan charge-offs.  Any increase in its
allowance for loan losses or loan charge-offs as required by these regulatory
agencies could have a material adverse effect on its results of operations and
financial condition.
 
 The
Corporation’s Ability To Pay Dividends Is Subject to Limitations
 
 The
Corporation is a bank holding company and its operations are conducted by First
Keystone National Bank, which is a separate and distinct legal
entity.  Substantially all of the Corporation’s assets are held by
First Keystone National Bank.
 
 The
Corporation’s ability to pay dividends depends on its receipt of dividends from
First Keystone National Bank, is its primary source of
dividends.  Dividend payments from First Keystone National Bank are
subject to legal and regulatory limitations, generally based on net profits and
retained earnings, imposed by the various banking regulatory
agencies.  The ability of banking subsidiaries to pay dividends is
also subject to their profitability, financial condition, capital expenditures
and other cash flow requirements.  There is no assurance that First
Keystone National Bank will be able to pay dividends in the future or that the
Corporation will generate adequate cash flow to pay dividends in the
future.  The Corporation’s failure to pay dividends on its common
stock could have material adverse effect on the market price of its common
stock.
 
 ITEM
1B.     UNRESOLVED STAFF COMMENTS
 
 Not
Applicable.
 
 ITEM
2.        DESCRIPTION OF
PROPERTIES
 
 The
Corporation and its subsidiary occupies sixteen properties in Columbia, Luzerne,
Montour, and Monroe counties in Pennsylvania, which are used principally as
banking offices. Properties owned are:
 
 ·
              Main
      Office located at 111 West Front Street, Berwick, Pennsylvania
      18603;
 ·
              Salem
      Office located at 400 Fowler Avenue, Berwick, Pennsylvania
      18603;
 ·
              Freas
      Avenue Office located at 701 Freas Avenue, Berwick, Pennsylvania
      18603;
 ·
              Scott
      Township Office located at Central Road and Route 11, Bloomsburg,
      Pennsylvania 17815;
 ·
              Mifflinville
      Office located at Third and Race Streets, Mifflinville, Pennsylvania
      18631;
 ·
              Hanover
      Township Office located at 1540 Sans Souci Highway, Wilkes-Barre,
      Pennsylvania 18706;
 ·
              Danville
      Office located at 1519 Bloom Road, Danville, Pennsylvania
      17821;
 ·
              Mountainhome
      Office located at Route 390 & Price’s Drive, Mountainhome,
      Pennsylvania 18342;
 ·
              Brodheadsville
      Office located at Route 209, Brodheadsville, Pennsylvania
      18322;
 ·
              Swiftwater
      Office located at Route 611, Swiftwater, Pennsylvania
    18370;
 ·
              Vacant
      lot held for expansion located at 117-119 West Front Street, Berwick,
      Pennsylvania 18603;
 ·
              Parking
      lot located at Second and Market Streets, Berwick, Pennsylvania 18603;
      and
 ·
              16
      ATM’s located in Columbia, Luzerne, Montour, and Monroe
      counties.
 
 Properties
leased are:
 
 ·
              Briar
      Creek Office located inside the Giant Market at 50 Briar Creek Plaza,
      Berwick, Pennsylvania 18603;
 ·
              Nescopeck
      Office located at 437 West Third Street, Nescopeck, Pennsylvania
      18635;
 ·
              Kingston
      Office located at 179 South Wyoming Avenue, Kingston, Pennsylvania
      18704;
 ·
              Stroudsburg
      Office located at 559 Main Street, Stroudsburg, Pennsylvania
      18360;
 ·
              Operations
      Center located at 105 Market Street, Berwick, Pennsylvania
      18603;
 ·
              Vacant
      lot held for expansion located at State Route 309, Mountaintop,
      Pennsylvania 18707.
  10
  ITEM
3.        LEGAL PROCEEDINGS
 
 The
Corporation and/or the Bank are defendants in various legal proceedings arising
in the ordinary course of their business.  However, in the opinion of
management of the Corporation and the Bank, there are no proceedings pending to
which the Corporation and the Bank is a party or to which their property is
subject, which, if determined adversely to the Corporation and the Bank, would
be material in relation to the Corporation's and Bank's individual profits or
financial condition, nor are there any proceedings pending other than ordinary
routine litigation incident to the business of the Corporation and the
Bank.  In addition, no material proceedings are pending or are known
to be threatened or contemplated against the Corporation and the Bank by
government authorities or others.
 
 
 ITEM
4.        SUBMISSION OF MATTERS TO A
VOTE OF SECURITY HOLDERS
 
 No matter
was submitted during the fourth quarter of the fiscal year covered by this
report to a vote of security holders through the solicitation of proxies or
otherwise.
 
 PART
II
 
 ITEM 5.
              MARKET
      FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDERMATTERS
      AND ISSUER PURCHASES OF EQUITY
SECURITIES
 
 The
Corporation's Common Stock is traded in the over-the-counter market on the OTC
Bulletin Board under the symbol “FKYS.OB”.  The following table sets
forth:
 
 ·
              The
      quarterly high and low prices for a share of the Corporation's Common
      Stock during the periods indicated as reported to the management of the
      Corporation and
 ·
              Quarterly
      dividends on a share of the Common Stock with respect to each quarter
      since January 1, 2007.
 
 
 MARKET
      VALUE OF COMMON STOCKPer
      Share2008:
                      
                      High
                      
                      
                      Low
                      
                      
                      DividendFirst
      quarter
                      
                      $
                      18.00
                      
                      
                      $
                      15.25
                      
                      
                      $
                      .22Second
      quarter
                      
                      $
                      18.00
                      
                      
                      $
                      14.25
                      
                      
                      $
                      .22Third
      quarter
                      
                      $
                      18.00
                      
                      
                      $
                      15.50
                      
                      
                      $
                      .22Fourth
      quarter
                      
                      $
                      16.00
                      
                      
                      $
                      13.50
                      
                      
                      $
                      .232007:First
      quarter
                      
                      $
                      19.00
                      
                      
                      $
                      17.50
                      
                      
                      $
                      .22Second
      quarter
                      
                      $
                      21.75
                      
                      
                      $
                      17.90
                      
                      
                      $
                      .22Third
      quarter
                      
                      $
                      19.25
                      
                      
                      $
                      17.00
                      
                      
                      $
                      .22Fourth
      quarter
                      
                      $
                      18.25
                      
                      
                      $
                      15.80
                      
                      
                      $
                      .22
  As of
December 31, 2008, the Corporation had approximately 824 shareholders of
record.
 
 The
Corporation has paid dividends since commencement of business in
1984.  It is the present intention of the Corporation's Board of
Directors to continue the dividend payment policy; however, further dividends
must necessarily depend upon earnings, financial condition, appropriate legal
restrictions and other factors relevant at the time the Board of Directors of
the Corporation considers dividend policy.  Cash available for
dividend distributions to shareholders of the Corporation must initially come
from dividends paid by the Bank to the Corporation.  Therefore, the
restrictions on the Bank's dividend payments are directly applicable to the
Corporation.
  11
 
 Transfer
Agent:
 
 Registrar
      and Transfer Company
                (800)
      368-594810
      Commerce DriveCranford,
      NJ 07016-3752
 
 The
following brokerage firms make a market in First Keystone Corporation common
stock:
 
 RBC
      Dain Rauscher
                (800)
      223-4207Janney
      Montgomery Scott LLC
                (800)
      526-6397Stifel
      Nicolaus & Co. Inc.
                (800)
      223-6807Boenning
      & Scattergood, Inc.
                (800)
      883-8383
  Dividend Restrictions on the
Bank
 
 The OCC
rules govern the payment of dividends by national
banks.  Consequently, the Bank, which is subject to these rules, may
not pay dividends from capital (unimpaired common and preferred stock
outstanding) but only from retained earnings after deducting losses and bad
debts therefrom.  To the extent that (1) the Bank has capital
surplus in an amount in excess of common capital and (2) the Bank can prove
that such surplus resulted from prior period earnings, the Bank, upon approval
of the OCC, may transfer earned surplus to retained earnings and thereby
increase its dividend capacity.
 
 The Bank
may not pay any dividends on its capital stock during a period in which it may
be in default in the payment of its assessment for a deposit insurance premium
due to the FDIC, nor may it pay dividends on Common Stock until any cumulative
dividends on the Bank's preferred stock (if any) have been paid in full. The
Bank has never been in default in the payments of its assessments to the FDIC;
and the Bank has no outstanding preferred stock. In addition, under the Federal
Deposit Insurance Act (912 U.S.C. Section 1818), dividends cannot be declared
and paid if the OCC obtains a cease and desist order because, in the opinion of
the OCC, such payment would constitute an unsafe and unsound banking practice.
As of December 31, 2008 that was a restriction of $424,000 on retained earnings
wherein dividends that could be paid to the Corporation by the Bank would be
available after 2009 net earnings exceed the restriction of
$424,000.
 
 Dividend Restrictions on the
Corporation
 
 Under the
Pennsylvania Business Corporation Law of 1988, as amended, the Corporation may
not pay a dividend if, after giving effect thereto, either:
 
 ·
              The
      Corporation would be unable to pay its debts as they become due in the
      usual course of business or;
 ·
              The
      Corporation's total assets would be less than its total
      liabilities.
 
 The
determination of total assets and liabilities may be based upon:
 
 ·
              Financial
      statements prepared on the basis of generally accepted accounting
      principles,
 ·
              Financial
      statements that are prepared on the basis of other accounting practices
      and principles that are reasonable under the circumstances,
      or;
 ·
              A
      fair valuation or other method that is reasonable under the
      circumstances.
 
 Equity Compensation Plan
Information
 
 Information
regarding the Corporation’s equity compensation plan is incorporated herein by
reference from the “Equity Compensation Plan Information” section of the
Corporation’s 2009 definitive proxy statement filed on Schedule
14A.
  12
  PERFORMANCE
GRAPH
 
 The
following graph and table compare the cumulative total shareholder return on the
corporation's common stock during the period December 31, 2003, through and
including December 31, 2008, with
 
 ·
              the
      cumulative total return on the SNL Securities Corporate Performance
      Index1
      for banks with less than $500 million in total assets in the Middle
      Atlantic area2,
      and
 ·
              the
      cumulative total return for all United States stocks traded on the NASDAQ
      Stock Market.
 
 The
comparison assumes $100 was invested on December 31, 2003, in the corporation’s
common stock and in each of the indices below and assumes further the
reinvestment of dividends into the applicable securities.  The
shareholder return shown on the graph and table below is not necessarily
indicative of future performance.
 
 FIRST KEYSTONE
CORPORATION
 Total
Return Performance
  
 
 Period Ending12/31/03
                        
                        
                        12/31/04
                        
                        
                        12/31/05
                        
                        
                        12/31/06
                        
                        
                        12/31/07
                        
                        
                        12/31/08First
      Keystone Corporation
                        
                        
                        100.00
                        
                        
                        
                        97.27
                        
                        
                        
                        90.36
                        
                        
                        
                        88.32
                        
                        
                        
                        81.34
                        
                        
                        
                        78.91NASDAQ
      - Total US
                        
                        
                        100.00
                        
                        
                        
                        108.59
                        
                        
                        
                        110.08
                        
                        
                        
                        120.56
                        
                        
                        
                        132.39
                        
                        
                        
                        78.72SNL
      <$500M Bank Index
                        
                        
                        100.00
                        
                        
                        
                        113.32
                        
                        
                        
                        118.18
                        
                        
                        
                        134.41
                        
                        
                        
                        107.71
                        
                        
                        
                        69.02
  1 SNL
Securities is a research and publishing firm specializing in the collection and
dissemination of data on the banking, thrift and financial services
industries.
 2The Middle Atlantic area
comprises the states of Delaware, Pennsylvania, Maryland, New Jersey, New York,
the District of Columbia and Puerto Rico.
  13
  ITEM
6.        SELECTED FINANCIAL
DATA
 
 (Amounts
in thousands, except per share)
 
 Year Ended December
    31,2008
                                        
                                        
                                        2007
                                        
                                        
                                        2006
                                        
                                        
                                        2005
                                        
                                        
                                        2004SELECTED
      FINANCIAL  DATA:Total
      Assets
                                        
                                        $
                                        714,898
                                        
                                        
                                        $
                                        681,207
                                        
                                        
                                        $
                                        525,920
                                        
                                        
                                        $
                                        512,399
                                        
                                        
                                        $
                                        497,615Total
      Investment securities
                                        
                                        
                                        243,165
                                        
                                        
                                        
                                        246,059
                                        
                                        
                                        
                                        243,938
                                        
                                        
                                        
                                        251,536
                                        
                                        
                                        
                                        239,053Net
      loans
                                        
                                        
                                        403,172
                                        
                                        
                                        
                                        371,557
                                        
                                        
                                        
                                        248,086
                                        
                                        
                                        
                                        230,917
                                        
                                        
                                        
                                        229,972Total
      Deposits
                                        
                                        
                                        504,633
                                        
                                        
                                        
                                        493,041
                                        
                                        
                                        
                                        384,020
                                        
                                        
                                        
                                        362,796
                                        
                                        
                                        
                                        357,956Stockholders'
      equity
                                        
                                        
                                        69,147
                                        
                                        
                                        
                                        70,924
                                        
                                        
                                        
                                        53,387
                                        
                                        
                                        
                                        53,443
                                        
                                        
                                        
                                        53,312SELECTED
      OPERATING DATA:Interest
      income
                                        
                                        $
                                        37,638
                                        
                                        
                                        $
                                        31,899
                                        
                                        
                                        $
                                        28,577
                                        
                                        
                                        $
                                        26,382
                                        
                                        
                                        $
                                        25,036Interest
      expense
                                        
                                        
                                        18,116
                                        
                                        
                                        
                                        17,785
                                        
                                        
                                        
                                        14,972
                                        
                                        
                                        
                                        11,621
                                        
                                        
                                        
                                        10,006Net
      interest income
                                        
                                        $
                                        19,522
                                        
                                        
                                        $
                                        14,114
                                        
                                        
                                        $
                                        13,605
                                        
                                        
                                        $
                                        14,761
                                        
                                        
                                        $
                                        15,030Provision
      for loan losses
                                        
                                        
                                        700
                                        
                                        
                                        
                                        150
                                        
                                        
                                        
                                        500
                                        
                                        
                                        
                                        750
                                        
                                        
                                        
                                        1,750Net
      interest income after provision for loan and lease losses
                                        
                                        $
                                        18,822
                                        
                                        
                                        $
                                        13,964
                                        
                                        
                                        $
                                        13,105
                                        
                                        
                                        $
                                        14,011
                                        
                                        
                                        $
                                        13,280Other
      income
                                        
                                        
                                        4,046
                                        
                                        
                                        
                                        4,199
                                        
                                        
                                        
                                        3,788
                                        
                                        
                                        
                                        3,782
                                        
                                        
                                        
                                        4,596Other
      expense
                                        
                                        
                                        13,923
                                        
                                        
                                        
                                        10,645
                                        
                                        
                                        
                                        9,515
                                        
                                        
                                        
                                        9,583
                                        
                                        
                                        
                                        9,426Income
      before income taxes
                                        
                                        $
                                        8,945
                                        
                                        
                                        $
                                        7,518
                                        
                                        
                                        $
                                        7,378
                                        
                                        
                                        $
                                        8,210
                                        
                                        
                                        $
                                        8,450Income
      tax expense
                                        
                                        
                                        1,394
                                        
                                        
                                        
                                        1,391
                                        
                                        
                                        
                                        1,188
                                        
                                        
                                        
                                        1,363
                                        
                                        
                                        
                                        1,663Net
      income
                                        
                                        $
                                        7,551
                                        
                                        
                                        $
                                        6,127
                                        
                                        
                                        $
                                        6,190
                                        
                                        
                                        $
                                        6,847
                                        
                                        
                                        $
                                        6,787PER
      COMMON SHARE DATA:Net
      income
                                        
                                        $
                                        1.39
                                        
                                        
                                        $
                                        1.31
                                        
                                        
                                        $
                                        1.35
                                        
                                        
                                        $
                                        1.48
                                        
                                        
                                        $
                                        1.47Cash
      dividends
                                        
                                        
                                        .89
                                        
                                        
                                        
                                        .88
                                        
                                        
                                        
                                        .85
                                        
                                        
                                        
                                        .78
                                        
                                        
                                        
                                        .70PERFORMANCE
      RATIOS:Return
      on average assets
                                        
                                        
                                        1.08
                                        %
                                        
                                        
                                        1.09
                                        %
                                        
                                        
                                        1.20
                                        %
                                        
                                        
                                        1.35
                                        %
                                        
                                        
                                        1.37
                                        %Return
      on average equity
                                        
                                        
                                        10.72
                                        %
                                        
                                        
                                        10.48
                                        %
                                        
                                        
                                        11.76
                                        %
                                        
                                        
                                        12.65
                                        %
                                        
                                        
                                        12.76
                                        %Dividend
      payout ratio
                                        
                                        
                                        64.12
                                        %
                                        
                                        
                                        68.25
                                        %
                                        
                                        
                                        62.63
                                        %
                                        
                                        
                                        52.61
                                        %
                                        
                                        
                                        47.41
                                        %Average
      equity to average assets ratio
                                        
                                        
                                        10.00
                                        %
                                        
                                        
                                        10.37
                                        %
                                        
                                        
                                        10.19
                                        %
                                        
                                        
                                        10.69
                                        %
                                        
                                        
                                        10.76
                                        %
  14
  ITEM 7.
              MANAGEMENT'S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND
      RESULTS OF OPERATIONS
 
 The
purpose of Management’s Discussion and Analysis of First Keystone Corporation, a
bank holding company (the Corporation), and its wholly owned subsidiary, First
Keystone National Bank (the Bank), is to assist the reader in reviewing the
financial information presented and should be read in conjunction with the
consolidated financial statements and other financial data contained herein.
Refer to Forward Looking Statements on page 1 for detailed
information.
 
 This
annual report contains certain forward-looking statements (as defined in the
Private Securities Litigation Reform Act of 1995), which reflect management’s
beliefs and expectations based on information currently available. These
forward-looking statements are inherently subject to significant risks and
uncertainties, including changes in general economic and financial market
conditions, the Corporation’s ability to effectively carry out its business
plans and changes in regulatory or legislative requirements. Other factors that
could cause or contribute to such differences are changes in competitive
conditions. Although management believes the expectations reflected in such
forward-looking statements are reasonable, actual results may differ
materially.
 
 ACQUISITION
 On
November 1, 2007, the Corporation acquired Pocono Community Bank (hereinafter
referred to as Pocono) of Stroudsburg, Pennsylvania. Pocono was a $120 million
bank which operated four full-service banking offices in Monroe County,
Pennsylvania. Period-to-period comparisons and the Management’s Discussion are
impacted by this acquisition. The tables in Management’s Discussion include
contributions of this acquisition as well as internal changes. Refer to Note 2
on page 43 of the Notes to Consolidated Financial Statements for detailed
information.
 
 RESULTS
OF OPERATIONS
 Year
Ended December 31, 2008 Versus Year Ended December 31, 2007
 Net
income increased to $7,551,000 for the year ended December 31, 2008, as compared
to $6,127,000 for the prior year, an increase of 23.2%. Earnings per share, both
basic and diluted, for 2008 were $1.39 as compared to $1.31 in 2007. Cash
dividends per share increased to $.89 in 2008 from $.88 in 2007, an increase of
1.1%. The Corporation’s return on average assets was 1.08% in 2008 as compared
to 1.09% in 2007. Return on average equity increased to 10.72% in 2008 from
10.48% in 2007. An increase in earning asset levels resulted in an overall
increase of interest income to $37,638,000 up $5,739,000 or 18.0% from 2007.
Likewise, there was the accompanying increase in deposits and borrowings which
resulted in interest expense of $18,116,000 in 2008, an increase of $331,000 or
1.9% from 2007.
 
 Net
interest income, as indicated below in Table 1, increased by $5,408,000 or 38.3%
to $19,522,000 for the year ended December 31, 2008. The Corporation's net
interest income on a fully taxable equivalent basis increased by $5,917,000, or
38.2% to $21,410,000 in 2008 as compared to an increase of $193,000, or 1.3% to
$15,493,000 in 2007.
 
 Year
Ended December 31, 2007 Versus Year Ended December 31, 2006
 Net
income decreased to $6,127,000 for the year ended December 31, 2007, as compared
to $6,190,000 for the prior year, a decrease of 1.0%. Earnings per share, both
basic and diluted, for 2007 were $1.31 as compared to $1.35 in 2006. Cash
dividends per share increased to $.88 in 2007 from $.85 in 2006, an increase of
3.5%. The Corporation’s return on average assets was 1.09% in 2007 as compared
to 1.20% in 2006. Return on average equity decreased to 10.48% in 2007 from
11.76% in 2006. An increase in earning asset levels resulted in an overall
increase of interest income to $31,899,000 up $3,322,000 or 11.6% from 2006.
Likewise, there was the accompanying increase in deposits and borrowings which
resulted in interest expense of $17,785,000 in 2007, an increase of $2,813,000
or 18.8% from 2006.
 
 
 Table
1  —  Net Interest Income
  (Amounts
      in thousands)
                      
                      2008/2007
                      
                      
                      2007/2006Increase/(Decrease)
                      
                      
                      Increase/(Decrease)2008
                      
                      
                      Amount
                      
                      
                      %
                      
                      
                      2007
                      
                      
                      Amount
                      
                      
                      %
                      
                      
                      2006Interest
      Income
                      
                      $
                      37,638
                      
                      
                      $
                      5,739
                      
                      
                      
                      18.0
                      
                      
                      $
                      31,899
                      
                      
                      $
                      3,322
                      
                      
                      
                      11.6
                      
                      
                      $
                      28,577Interest
      Expense
                      
                      
                      18,116
                      
                      
                      
                      331
                      
                      
                      
                      1.9
                      
                      
                      
                      17,785
                      
                      
                      
                      2,813
                      
                      
                      
                      18.8
                      
                      
                      
                      14,972Net
      Interest Income
                      
                      
                      19,522
                      
                      
                      
                      5,408
                      
                      
                      
                      38.3
                      
                      
                      
                      14,114
                      
                      
                      
                      509
                      
                      
                      
                      3.7
                      
                      
                      
                      13,605Tax
      Equivalent Adjustment
                      
                      
                      1,888
                      
                      
                      
                      509
                      
                      
                      
                      36.9
                      
                      
                      
                      1,379
                      
                      
                      
                      (316
                      )
                      
                      
                      (18.6
                      )
                      
                      
                      1,695Net
      Interest Income (fully tax equivalent)
                      
                      $
                      21,410
                      
                      
                      $
                      5,917
                      
                      
                      
                      38.2
                      
                      
                      $
                      15,493
                      
                      
                      $
                      193
                      
                      
                      
                      1.3
                      
                      
                      $
                      15,300
  15
  Table
2   —   Distribution of Assets, Liabilities and
Stockholders' Equity
 
 2008
                                              
                                              
                                              2007
                                              
                                              
                                              2006Average
                                              
                                              
                                              Revenue/
                                              
                                              
                                              Yield/
                                              
                                              
                                              Average
                                              
                                              
                                              Revenue/
                                              
                                              
                                              Yield/
                                              
                                              
                                              Average
                                              
                                              
                                              Revenue/
                                              
                                              
                                              Yield/Balance
                                              
                                              
                                              Expense
                                              
                                              
                                              Rate
                                              
                                              
                                              Balance
                                              
                                              
                                              Expense
                                              
                                              
                                              Rate
                                              
                                              
                                              Balance
                                              
                                              
                                              Expense
                                              
                                              
                                              RateInterest
      Earning Assets:Loans:Commercial1
                                              
                                              $
                                              33,029
                                              
                                              
                                              $
                                              2,822
                                              
                                              
                                              
                                              8.54
                                              %
                                              
                                              $
                                              21,054
                                              
                                              
                                              $
                                              1,938
                                              
                                              
                                              
                                              9.20
                                              %
                                              
                                              $
                                              28,120
                                              
                                              
                                              $
                                              2,003
                                              
                                              
                                              
                                              7.12
                                              %Real
      Estate1
                                              
                                              
                                              333,336
                                              
                                              
                                              
                                              21,663
                                              
                                              
                                              
                                              6.50
                                              %
                                              
                                              
                                              234,465
                                              
                                              
                                              
                                              15,993
                                              
                                              
                                              
                                              6.82
                                              %
                                              
                                              
                                              198,854
                                              
                                              
                                              
                                              13,200
                                              
                                              
                                              
                                              6.64
                                              %Installment
      Loans, Net1,2
                                              
                                              
                                              25,498
                                              
                                              
                                              
                                              1,136
                                              
                                              
                                              
                                              4.46
                                              %
                                              
                                              
                                              21,097
                                              
                                              
                                              
                                              1,263
                                              
                                              
                                              
                                              5.99
                                              %
                                              
                                              
                                              17,681
                                              
                                              
                                              
                                              1,402
                                              
                                              
                                              
                                              7.93
                                              %Fees
      on Loans
                                              
                                              
                                              —
                                              
                                              
                                              
                                              62
                                              
                                              
                                              
                                              —
                                              %
                                              
                                              
                                              —
                                              
                                              
                                              
                                              (31
                                              )
                                              
                                              
                                              —
                                              %
                                              
                                              
                                              —
                                              
                                              
                                              
                                              (39
                                              )
                                              
                                              
                                              —
                                              %Total
      Loans (Including Fees)3
                                              
                                              $
                                              391,863
                                              
                                              
                                              $
                                              25,683
                                              
                                              
                                              
                                              6.55
                                              %
                                              
                                              $
                                              276,616
                                              
                                              
                                              $
                                              19,163
                                              
                                              
                                              
                                              6.93
                                              %
                                              
                                              $
                                              244,655
                                              
                                              
                                              $
                                              16,566
                                              
                                              
                                              
                                              6.77
                                              %Investment
      Securities:Taxable
                                              
                                              $
                                              156,011
                                              
                                              
                                              $
                                              8,623
                                              
                                              
                                              
                                              5.53
                                              %
                                              
                                              $
                                              179,431
                                              
                                              
                                              $
                                              9,894
                                              
                                              
                                              
                                              5.51
                                              %
                                              
                                              $
                                              156,109
                                              
                                              
                                              $
                                              8,488
                                              
                                              
                                              
                                              5.44
                                              %Tax
      Exempt1
                                              
                                              
                                              78,902
                                              
                                              
                                              
                                              5,128
                                              
                                              
                                              
                                              6.50
                                              %
                                              
                                              
                                              66,844
                                              
                                              
                                              
                                              4,124
                                              
                                              
                                              
                                              6.17
                                              %
                                              
                                              
                                              82,669
                                              
                                              
                                              
                                              5,188
                                              
                                              
                                              
                                              6.28
                                              %Total
      Investment Securities
                                              
                                              $
                                              234,913
                                              
                                              
                                              $
                                              13,751
                                              
                                              
                                              
                                              5.85
                                              %
                                              
                                              $
                                              246,275
                                              
                                              
                                              $
                                              14,018
                                              
                                              
                                              
                                              5.69
                                              %
                                              
                                              $
                                              238,778
                                              
                                              
                                              $
                                              13,676
                                              
                                              
                                              
                                              5.73
                                              %Interest
      Bearing Deposits in Banks
                                              
                                              
                                              3,515
                                              
                                              
                                              
                                              79
                                              
                                              
                                              
                                              2.25
                                              %
                                              
                                              
                                              1,086
                                              
                                              
                                              
                                              66
                                              
                                              
                                              
                                              6.05
                                              %
                                              
                                              
                                              606
                                              
                                              
                                              
                                              31
                                              
                                              
                                              
                                              5.12
                                              %Federal
      Funds Sold
                                              
                                              
                                              436
                                              
                                              
                                              
                                              13
                                              
                                              
                                              
                                              2.98
                                              %
                                              
                                              
                                              688
                                              
                                              
                                              
                                              31
                                              
                                              
                                              
                                              4.56
                                              %
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              %Total
      Other Interest-Earning Assets
                                              
                                              
                                              3,951
                                              
                                              
                                              
                                              92
                                              
                                              
                                              
                                              2.33
                                              %
                                              
                                              
                                              1,774
                                              
                                              
                                              
                                              97
                                              
                                              
                                              
                                              5.47
                                              %
                                              
                                              
                                              606
                                              
                                              
                                              
                                              31
                                              
                                              
                                              
                                              5.12
                                              %Total
      Interest-Earning Assets
                                              
                                              $
                                              630,727
                                              
                                              
                                              $
                                              39,526
                                              
                                              
                                              
                                              6.27
                                              %
                                              
                                              $
                                              524,665
                                              
                                              
                                              $
                                              33,278
                                              
                                              
                                              
                                              6.34
                                              %
                                              
                                              $
                                              484,039
                                              
                                              
                                              $
                                              30,273
                                              
                                              
                                              
                                              6.25
                                              %Non-Interest
      Earning Assets:Cash
      and Due From Banks
                                              
                                              $
                                              9,876
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              8,132
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              7,437Allowance
      for Loan Losses
                                              
                                              
                                              (5,163
                                              )
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              (3,960
                                              )
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              (3,662
                                              )Premises
      and Equipment
                                              
                                              
                                              8,427
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              5,519
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              4,991Foreclosed
      Assets Held for Sale
                                              
                                              
                                              109
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              229Other
      Assets
                                              
                                              
                                              56,635
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              29,741
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              23,707Total
      Non-Interest Earning Assets
                                              
                                              
                                              69,884
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              39,432
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              32,702Total
      Assets
                                              
                                              $
                                              700,611
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              564,097
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              516,741Interest-Bearing
      Liabilities:Savings,
      NOW Accounts, and Money Markets
                                              
                                              $
                                              198,916
                                              
                                              
                                              $
                                              3,113
                                              
                                              
                                              
                                              1.56
                                              %
                                              
                                              $
                                              154,200
                                              
                                              
                                              $
                                              3,681
                                              
                                              
                                              
                                              2.39
                                              %
                                              
                                              $
                                              136,481
                                              
                                              
                                              $
                                              2,921
                                              
                                              
                                              
                                              2.14
                                              %Time
      Deposits
                                              
                                              
                                              259,480
                                              
                                              
                                              
                                              10,795
                                              
                                              
                                              
                                              4.16
                                              %
                                              
                                              
                                              214,232
                                              
                                              
                                              
                                              9,876
                                              
                                              
                                              
                                              4.61
                                              %
                                              
                                              
                                              202,780
                                              
                                              
                                              
                                              8,263
                                              
                                              
                                              
                                              4.07
                                              %Short-Term
      Borrowings
                                              
                                              
                                              11,883
                                              
                                              
                                              
                                              191
                                              
                                              
                                              
                                              1.61
                                              %
                                              
                                              
                                              14,551
                                              
                                              
                                              
                                              735
                                              
                                              
                                              
                                              5.05
                                              %
                                              
                                              
                                              6,909
                                              
                                              
                                              
                                              352
                                              
                                              
                                              
                                              5.09
                                              %Long-Term
      Borrowings
                                              
                                              
                                              71,221
                                              
                                              
                                              
                                              3,539
                                              
                                              
                                              
                                              4.97
                                              %
                                              
                                              
                                              58,345
                                              
                                              
                                              
                                              2,901
                                              
                                              
                                              
                                              4.97
                                              %
                                              
                                              
                                              62,376
                                              
                                              
                                              
                                              2,895
                                              
                                              
                                              
                                              4.64
                                              %Fed
      Funds Purchased
                                              
                                              
                                              351
                                              
                                              
                                              
                                              15
                                              
                                              
                                              
                                              4.27
                                              %
                                              
                                              
                                              11
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              4.65
                                              %
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              %Securities
      Sold U/A to Repurchase
                                              
                                              
                                              17,894
                                              
                                              
                                              
                                              463
                                              
                                              
                                              
                                              2.59
                                              %
                                              
                                              
                                              14,553
                                              
                                              
                                              
                                              592
                                              
                                              
                                              
                                              4.07
                                              %
                                              
                                              
                                              13,411
                                              
                                              
                                              
                                              542
                                              
                                              
                                              
                                              4.04
                                              %Total
      Interest-Bearing Liabilities
                                              
                                              $
                                              559,745
                                              
                                              
                                              $
                                              18,116
                                              
                                              
                                              
                                              3.24
                                              %
                                              
                                              $
                                              455,892
                                              
                                              
                                              $
                                              17,785
                                              
                                              
                                              
                                              3.90
                                              %
                                              
                                              $
                                              421,957
                                              
                                              
                                              $
                                              14,973
                                              
                                              
                                              
                                              3.55
                                              %Non-Interest
      Bearing Liabilities:Demand
      Deposits
                                              
                                              $
                                              57,102
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              43,795
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              39,076Other
      Liabilities
                                              
                                              
                                              13,315
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              5,940
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              3,074Stockholders’
      Equity
                                              
                                              
                                              70,449
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              58,470
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              52,634Total
      Liabilities/Stockholders' Equity
                                              
                                              $
                                              700,611
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              564,097
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              516,741Net
      Interest Income Tax Equivalent
                                              
                                              
                                              
                                              
                                              
                                              $
                                              21,410
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              15,493
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              15,300Net
      Interest Spread
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              3.03
                                              %
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              2.44
                                              %
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              2.70
                                              %Net
      Interest Margin
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              3.39
                                              %
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              2.95
                                              %
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              3.16
                                              %
 
 1Tax-exempt
income has been adjusted to a tax equivalent basis using an incremental rate of
34%, and statutory interest expense disallowance.
 2Installment
loans are stated net of unearned interest.
 3Average
loan balances include non-accrual loans.  Interest income on
non-accrual loans is not included.
  16
  NET
INTEREST INCOME
 
 The major
source of operating income for the Corporation is net interest income. Net
interest income is the difference between interest income on earning assets,
such as loans and securities, and the interest expense on liabilities used to
fund those assets, including deposits and other borrowings. The amount of
interest income is dependent upon both the volume of earning assets and the
level of interest rates. In addition, the volume of non-performing loans affects
interest income. The amount of interest expense varies with the amount of funds
needed to support earning assets, interest rates paid on deposits and borrowed
funds, and finally, the level of interest free deposits.
 
 Table 2
on the preceding pages provides a summary of average outstanding balances of
earning assets and interest bearing liabilities with the associated interest
income and interest expense as well as average tax equivalent rates earned and
paid as of year-end 2008, 2007, and 2006.
 
 The yield
on earning assets was 6.27% in 2008, 6.34% in 2007, and 6.25% in 2006. The rate
paid on interest bearing liabilities was 3.24% in 2008, 3.90% in 2007, and 3.55%
in 2006. This resulted in an increase in our net interest spread to 3.03% in
2008, as compared to 2.44% in 2007 and 2.70% in 2006.
 
 As Table
2 illustrates, the net interest margin, which is interest income less interest
expenses divided by average earnings assets, was 3.39% in 2008 as compared to
2.95% in 2007 and 3.16% in 2006. The net interest margins are presented on a
tax-equivalent basis. The increase in net interest margin in 2008 was due
primarily to the decline in interest paid on interest bearing liabilities this
year. The decreases in net interest margin in 2007 and 2006 were due primarily
to the increased interest paid on  interest bearing
liabilities.  This was a result of more interest bearing liabilities
repricing than earning assets.
 
 The
improvement in our net interest margin came from higher earning asset yields and
lower funding costs in 2008. The interest margin expansion was experienced as
the yield curve returned to its more normal upward sloping environment in 2008
as compared to the previous years.
 
 Table 3
sets forth changes in interest income and interest expense for the periods
indicated for each category of interest earning assets and interest bearing
liabilities. Information is provided on changes attributable to (I) changes in
volume (changes in average volume multiplied by prior rate); (ii) changes in
rate (changes in average rate multiplied by prior average volume); and, (iii)
changes in rate and volume (changes in average volume multiplied by change in
average rate).
 
 Interest
income exempt from federal tax was $4,112,000 in 2008, $3,118,000 in 2007, and
$3,755,000 in 2006.  Tax-exempt income has been adjusted to a
tax-equivalent basis using an incremental rate of 34%.
 
 In 2008,
the increase in net interest income of $5,917,000 resulted from an increase in
volume of $3,746,000 and an increase of $2,171,000 due to changes in rate. In
2007, the increase in net interest income of $193,000 resulted from an increase
in volume of $1,405,000 and a decrease of $1,212,000 due to changes in
rate.
  17
  Table
3  —  Changes in Income and Expense, 2008 and
2007
 
 (Amounts
      in thousands)
                                
                                2008 COMPARED TO 2007
                                
                                
                                2007 COMPARED TO 2006VOLUME
                                
                                
                                RATE
                                
                                
                                NET
                                
                                
                                VOLUME
                                
                                
                                RATE
                                
                                
                                NETInterest
      Income:Loans,
      Net
                                
                                $
                                7,984
                                
                                
                                $
                                (1,464
                                )
                                
                                $
                                6,520
                                
                                
                                $
                                2,164
                                
                                
                                $
                                433
                                
                                
                                $
                                2,597Taxable
      Investment Securities
                                
                                
                                (1,291
                                )
                                
                                
                                20
                                
                                
                                
                                (1,271
                                )
                                
                                
                                1,268
                                
                                
                                
                                138
                                
                                
                                
                                1,406Tax-Exempt
      Investment Securities
                                
                                
                                744
                                
                                
                                
                                260
                                
                                
                                
                                1,004
                                
                                
                                
                                (993
                                )
                                
                                
                                (71
                                )
                                
                                
                                (1,064
                                )Other
      Short-Term Investments
                                
                                
                                119
                                
                                
                                
                                (124
                                )
                                
                                
                                (5
                                )
                                
                                
                                60
                                
                                
                                
                                6
                                
                                
                                
                                66Total
      Interest Income
                                
                                $
                                7,556
                                
                                
                                $
                                (1,308
                                )
                                
                                $
                                6,248
                                
                                
                                $
                                2,499
                                
                                
                                $
                                506
                                
                                
                                $
                                3,005Interest
      Expense:Savings,
      Now, and Money Markets
                                
                                $
                                1,067
                                
                                
                                $
                                (1,635
                                )
                                
                                $
                                (568
                                )
                                
                                $
                                379
                                
                                
                                $
                                381
                                
                                
                                $
                                760Time
      Deposits
                                
                                
                                2,086
                                
                                
                                
                                (1,167
                                )
                                
                                
                                919
                                
                                
                                
                                467
                                
                                
                                
                                1,146
                                
                                
                                
                                1,613Short-Term
      Borrowings
                                
                                
                                (119
                                )
                                
                                
                                (410
                                )
                                
                                
                                (529
                                )
                                
                                
                                389
                                
                                
                                
                                (6
                                )
                                
                                
                                383Long-Term
      Borrowings
                                
                                
                                640
                                
                                
                                
                                (2
                                )
                                
                                
                                638
                                
                                
                                
                                (187
                                )
                                
                                
                                193
                                
                                
                                
                                6Securities
      Sold U/A to Repurchase
                                
                                
                                136
                                
                                
                                
                                (265
                                )
                                
                                
                                (129
                                )
                                
                                
                                46
                                
                                
                                
                                4
                                
                                
                                
                                50Total
      Interest Expense
                                
                                $
                                3,810
                                
                                
                                $
                                (3,479
                                )
                                
                                $
                                331
                                
                                
                                $
                                1,094
                                
                                
                                $
                                1,718
                                
                                
                                $
                                2,812Net
      Interest Income
                                
                                $
                                3,746
                                
                                
                                $
                                2,171
                                
                                
                                $
                                5,917
                                
                                
                                $
                                1,405
                                
                                
                                $
                                (1,212
                                )
                                
                                $
                                193
  
 The
change in interest due to both volume and yield/rate has been allocated to
change due to volume and change due to yield/rate in proportion to the absolute
value of the change in each.
 Balance
on non-accrual loans are included for computational
purposes.  Interest income on non-accrual loans is not
included.
 
 PROVISION
FOR LOAN LOSSES
 
 For the
year ended December 31, 2008, the provision for loan losses was $700,000 as
compared to $150,000 as of December
31, 2007 and $500,000 as of December 31, 2006. The provision in 2008, increased
primarily because of the increase in net charge-offs. Net charge-offs by the
Corporation for the fiscal year end December 31, 2008, 2007, and 2006, were
$551,000, $57,000, and $505,000, respectively.
 
 The
allowance for loan losses as a percentage of loans, net of unearned interest,
was 1.27% as of December 31, 2008, 1.34% as of December 31, 2007, 1.46% as of
December 31, 2006.
 
 On a
quarterly basis, the Corporation’s Board of Directors and management performs a
detailed analysis of the adequacy of the allowance for loan losses. This
analysis includes an evaluation of credit risk concentration, delinquency
trends, past loss experience, current economic conditions, composition of the
loan portfolio, classified loans and other relevant factors.
 
 The
Corporation will continue to monitor its allowance for loan losses and make
future adjustments to the allowance through the provision for loan losses as
conditions warrant. Although the Corporation believes that the allowance for
loan losses is adequate to provide for losses inherent in the loan portfolio,
there can be no assurance that future losses will not exceed the estimated
amounts or that additional provisions will not be required in the
future.
 
 The Bank
is subject to periodic regulatory examination by the Office of the Comptroller
of the Currency (OCC).  As part of the examination, the OCC will
assess the adequacy of the bank’s allowance for loan losses and may include
factors not considered by the Bank. In the event that an OCC examination results
in a conclusion that the Bank’s allowance for loan losses is not adequate, the
Bank may be required to increase its provision for loan losses.
  18
 
 NON-INTEREST
INCOME
 
 Non-interest
income is derived primarily from trust department revenue, service charges and
fees, income on bank owned life insurance, other miscellaneous revenue and the
gain on the sale of mortgage loans. In addition, investment securities gains or
losses also impact total non-interest income.
 
 For the
year ended December 31, 2008, non-interest income amounted to $4,046,000, a
decrease of $153,000, or 3.6% as compared to an increase of $411,000, or 10.9%
for the year ended December 31, 2007. Table 4 provides the major categories of
non-interest income and each respective change comparing the past three years.
Investment securities losses in 2008 was primarily the result of the sale of
equity securities at a loss and a other than temporary impairment charge in
other equity securities.
 
 Excluding
investment securities gains, non-interest income in 2008 increased $478,000, or
12.9% to $4,194,000. This compares to a increase of $309,000, or 9.1% in 2007
before investment securities gains. Income from the trust department, which
consists of fees generated from individual and corporate accounts, decreased in
2008 by $51,000, or 8.8% after increasing by $74,000, or 14.6% in
2007.  Decreased income from the trust department in 2008 was due
primarily to the decrease in market values of assets, especially equity
securities,  under management.
 
 Service
charges and fees, consisting primarily of service charges on deposit accounts,
was the largest source of non-interest income in 2008 and 2007. Service charges
and fees increased by $272,000, or 12.5% in 2008 compared to an increase of
$34,000, or 1.6% in 2007.
 
 Income on
Bank Owned Life Insurance (BOLI) increased $149,000 to $707,000 in 2008 as
compared to an increase of $86,000 to $558,000 in 2007. The income from BOLI
represents the increase in the cash surrender value of BOLI and is intended to
partially cover the costs of the Bank’s employee benefit plan, including group
life, disability, and health insurance.
 
 The gain
on sale of mortgages provided $136,000 in 2008 as compared to $89,000 in 2007.
The increase in gains on sale of mortgages was largely a function of the
increased originations and subsequent mortgage sales in the secondary market
during the past year. The Corporation continues to service the mortgages which
are sold, this servicing income provides an additional source of non-interest
income on an ongoing basis.
 
 Other
income, consisting primarily of safe deposit box rentals, income from the sale
of non-deposit products, and miscellaneous fees amounted to $366,000 for 2008,
an increase of $61,000 or 20.0% over the $305,000 other income reported in 2007.
The increased sale of non-deposit products, especially annuities, accounts for
the majority of the increase in 2008.
 
 Table
4  —  Non-Interest Income
 
 (Amounts
      in thousands)
                                                                                                    
                                                                                                    2008/2007
                                                                                                    
                                                                                                    
                                                                                                    2007/2006Increase/(Decrease)
                                                                                                    
                                                                                                    
                                                                                                    Increase/(Decrease)2008
                                                                                                    
                                                                                                    
                                                                                                    Amount
                                                                                                    
                                                                                                    
                                                                                                    %
                                                                                                    
                                                                                                    
                                                                                                    2007
                                                                                                    
                                                                                                    
                                                                                                    Amount
                                                                                                    
                                                                                                    
                                                                                                    %
                                                                                                    
                                                                                                    
                                                                                                    2006Trust
      Department
                                                                                                    
                                                                                                    $
                                                                                                    530
                                                                                                    
                                                                                                    
                                                                                                    $
                                                                                                    (51
                                                                                                    )
                                                                                                    
                                                                                                    
                                                                                                    (8.8
                                                                                                    )
                                                                                                    
                                                                                                    $
                                                                                                    581
                                                                                                    
                                                                                                    
                                                                                                    $
                                                                                                    74
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    14.6
                                                                                                    
                                                                                                    
                                                                                                    $
                                                                                                    507Service
      Charges and Fees
                                                                                                    
                                                                                                    
                                                                                                    2,455
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    272
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    12.5
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    2,183
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    34
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    1.6
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    2,149Income
      on Bank Owned Life Insurance
                                                                                                    
                                                                                                    
                                                                                                    707
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    149
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    26.7
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    558
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    86
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    18.2
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    472Gain
      on Sale of Mortgages
                                                                                                    
                                                                                                    
                                                                                                    136
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    47
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    52.8
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    89
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    50
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    128.2
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    39Other
                                                                                                    
                                                                                                    
                                                                                                    366
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    61
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    20.0
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    305
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    65
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    27.1
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    240Subtotal
                                                                                                    
                                                                                                    $
                                                                                                    4,194
                                                                                                    
                                                                                                    
                                                                                                    $
                                                                                                    478
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    12.9
                                                                                                    
                                                                                                    
                                                                                                    $
                                                                                                    3,716
                                                                                                    
                                                                                                    
                                                                                                    $
                                                                                                    309
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    9.1
                                                                                                    
                                                                                                    
                                                                                                    $
                                                                                                    3,407Investment
      Securities Gains (Losses)
                                                                                                    
                                                                                                    
                                                                                                    (148
                                                                                                    )
                                                                                                    
                                                                                                    
                                                                                                    (631
                                                                                                    )
                                                                                                    
                                                                                                    
                                                                                                    (130.6
                                                                                                    )
                                                                                                    
                                                                                                    
                                                                                                    483
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    102
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    26.8
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    381Total
                                                                                                    
                                                                                                    $
                                                                                                    4,046
                                                                                                    
                                                                                                    
                                                                                                    $
                                                                                                    (153
                                                                                                    )
                                                                                                    
                                                                                                    
                                                                                                    (3.6
                                                                                                    )
                                                                                                    
                                                                                                    $
                                                                                                    4,199
                                                                                                    
                                                                                                    
                                                                                                    $
                                                                                                    411
                                                                                                    
                                                                                                    
                                                                                                    
                                                                                                    10.9
                                                                                                    
                                                                                                    
                                                                                                    $
                                                                                                    3,788
  19
 
 NON-INTEREST
EXPENSE
 
 Non-interest
expense consists of salaries and benefits, occupancy, furniture and equipment,
and other miscellaneous expenses. Table 5 provides the yearly non-interest
expense by category, along with the amount, dollar changes, and percentage of
change. The increase in each of the non-interest expense categories reflects the
first full year of expenses from the Pocono acquisition in late
2007.
 
 Total
non-interest expense amounted to $13,923,000, an increase of $3,278,000, or
30.8% in 2008 compared to an increase of $1,130,000, or 11.9% in 2007. Expenses
associated with employees (salaries and employee benefits) continue to be the
largest non-interest expenditure. Salaries and employee benefits amounted to
52.8% of total non-interest expense in 2008 and 52.4% in 2007. Salaries and
employee benefits increased $1,774,000, or 31.8% in 2008 and $391,000, or 7.5%
in 2007. The increases in both years largely reflect normal salary adjustments
and increased benefit costs. The number of full time equivalent employees was
163 as of December 31, 2008, and 167 as of December 31, 2007.
 
 Net
occupancy expense increased $306,000, or 40.4% in 2008 as compared to an
increase of $150,000, or 24.7% in 2007. Furniture and equipment expense
increased $172,000, or 22.5% in 2008 compared to a increase of $13,000, or 1.7%
in 2007. The increases in occupancy and furniture and equipment expense in 2008
relate to the Pocono acquisition and to increases in rent and lease payments and
new equipment purchases. Other operating expenses increased $1,026,000, or 28.9%
in 2008 as compared to an increase of $576,000, or 19.4% in 2007. Increases in
professional fees, marketing, advertising, and miscellaneous expense associated
with the Pocono acquisition account for much of the increase in other operating
expenses in 2008.
 
 The
overall level of non-interest expense remains low, relative to our peers. In
fact, our total non-interest expense was less than 2% of average assets in both
2008 and 2007. Non-interest expense as a percentage of average assets under 2%
places us among the leaders in our peer financial institution categories in
controlling non-interest expense.
 
 Table
5  —  Non-Interest Expense
 
 (Amounts
      in thousands)
                                                                                
                                                                                2008/2007
                                                                                
                                                                                
                                                                                2007/2006Increase/(Decrease)
                                                                                
                                                                                
                                                                                Increase/(Decrease)2008
                                                                                
                                                                                
                                                                                Amount
                                                                                
                                                                                
                                                                                %
                                                                                
                                                                                
                                                                                2007
                                                                                
                                                                                
                                                                                Amount
                                                                                
                                                                                
                                                                                %
                                                                                
                                                                                
                                                                                2006Salaries
      and Employee Benefits
                                                                                
                                                                                $
                                                                                7,350
                                                                                
                                                                                
                                                                                $
                                                                                1,774
                                                                                
                                                                                
                                                                                
                                                                                31.8
                                                                                
                                                                                
                                                                                $
                                                                                5,576
                                                                                
                                                                                
                                                                                $
                                                                                391
                                                                                
                                                                                
                                                                                
                                                                                7.5
                                                                                
                                                                                
                                                                                $
                                                                                5,185Occupancy,
      Net
                                                                                
                                                                                
                                                                                1,064
                                                                                
                                                                                
                                                                                
                                                                                306
                                                                                
                                                                                
                                                                                
                                                                                40.4
                                                                                
                                                                                
                                                                                
                                                                                758
                                                                                
                                                                                
                                                                                
                                                                                150
                                                                                
                                                                                
                                                                                
                                                                                24.7
                                                                                
                                                                                
                                                                                
                                                                                608Furniture
      and Equipment
                                                                                
                                                                                
                                                                                936
                                                                                
                                                                                
                                                                                
                                                                                172
                                                                                
                                                                                
                                                                                
                                                                                22.5
                                                                                
                                                                                
                                                                                
                                                                                764
                                                                                
                                                                                
                                                                                
                                                                                13
                                                                                
                                                                                
                                                                                
                                                                                1.7
                                                                                
                                                                                
                                                                                
                                                                                751Other,
      Shares Tax, and Professional Service
                                                                                
                                                                                
                                                                                4,573
                                                                                
                                                                                
                                                                                
                                                                                1,026
                                                                                
                                                                                
                                                                                
                                                                                28.9
                                                                                
                                                                                
                                                                                
                                                                                3,547
                                                                                
                                                                                
                                                                                
                                                                                576
                                                                                
                                                                                
                                                                                
                                                                                19.4
                                                                                
                                                                                
                                                                                
                                                                                2,971Total
                                                                                
                                                                                $
                                                                                13,923
                                                                                
                                                                                
                                                                                $
                                                                                3,278
                                                                                
                                                                                
                                                                                
                                                                                30.8
                                                                                
                                                                                
                                                                                $
                                                                                10,645
                                                                                
                                                                                
                                                                                $
                                                                                1,130
                                                                                
                                                                                
                                                                                
                                                                                11.9
                                                                                
                                                                                
                                                                                $
                                                                                9,515
 
 INCOME
TAX EXPENSE
 
 Income
tax expense for the year ended December 31, 2008, was $1,394,000 as compared to
$1,391,000 and $1,188,000  for the years ended December 31, 2007, and
December 31, 2006, respectively. In 2008, our income tax expense increased
slightly even though income before taxes increased $1,427,000 to $8,945,000 from
$7,518,000 in 2007. An increase in tax exempt income reduced our income tax
liability in 2008. The corporation looks to maximize its tax-exempt interest
derived from both tax-free loans and tax-free municipal investments without
triggering alternative minimum tax. The effective income tax rate was 15.6% in
2008, 18.5% in 2007, and 16.1% in 2006. The limited availability of tax-free
municipal investments at attractive interest rates may result in a higher
effective tax rate in future years.
 
 FINANCIAL
CONDITION
 
 GENERAL
 
 Total
assets increased to $714,898,000, at year-end 2008, an increase of 4.9% over
year-end 2007. As of December 31, 2008, total deposits amounted to $504,633,000,
an increase of 2.4% over 2007. Assets as of December 31, 2007, were
$681,207,000, an increase of 29.5% over 2006, while total deposits as of
year-end 2007 amounted to $493,041,000, an increase of 28.4% from
2006.
 
 In both
2008 and 2007, deposit growth was used principally to fund loan growth. The
Corporation continues to maintain and manage its asset growth. Our strong equity
capital position provides us an opportunity to further leverage our asset
growth. Borrowings increased in both 2008 and 2007 by $23,870,000 and
$27,810,000, respectively. Increased borrowings in 2008 and 2007 helped fund
loan growth and other asset growth on the balance sheet. Core deposits, which
include demand deposits and interest bearing demand deposits (NOWs), money
market accounts, savings accounts, and time deposits of individuals continues to
be our most significant source of funds. In 2008 and 2007, several successful
sales campaigns attracted new customers and  generated growth in
retail certificates of deposit (time deposits of individuals) as well as
checking, savings and money market accounts.
  20
  EARNING
ASSETS
 
 Earning
assets are defined as those assets that produce interest income. By maintaining
a healthy asset utilization rate, i.e., the volume of earning assets as a
percentage of total assets, the Corporation maximizes income. The earning asset
ratio (average interest earning assets divided by average total assets) equaled
90.0% for 2008, compared to 93.0% for 2007 and 93.7% for 2006. This indicates
that the management of earning assets is a priority and non-earning assets,
primarily cash and due from banks, fixed assets and other assets, are
maintained  at minimal levels. The primary earning assets are loans
and investment securities.
 
 LOANS
 
 Total
loans, net of unearned income, increased to $408,367,000 as of December 31,
2008, as compared to a balance of $376,603,000 as of December 31, 2007. Table 6
provides data relating to the composition of the Corporation's loan portfolio on
the dates indicated. Total loans, net of unearned income increased $31,764,000,
or 8.4% in 2008 compared to an increase of $124,846,000, or 49.6% in
2007.
 
 The loan
portfolio is well diversified and increases in the portfolio in 2008 were
primarily in commercial real estate loans and tax exempt loans. In 2007, the
increase in loans was primarily in commercial real estate loans, tax exempt, and
real estate loans. The Corporation continues to originate and sell certain
long-term fixed rate residential mortgage loans which conform to secondary
market requirements. The Corporation derives ongoing income from the servicing
of mortgages sold in the secondary market.
 
 The
Corporation continues to internally underwrite each of its loans to comply with
prescribed policies and approval levels established by its Board of
Directors.
 
 Table
6  —  Loans Outstanding, Net of Unearned Income
 
 (Amounts
      in thousands)
                          
                          December 31,2008
                          
                          
                          2007
                          
                          
                          2006
                          
                          
                          2005
                          
                          
                          2004Commercial,
      financial and agricultural:Commercial
      secured by real estate
                          
                          $
                          206,095
                          
                          
                          $
                          190,803
                          
                          
                          $
                          123,673
                          
                          
                          $
                          92,930
                          
                          
                          $
                          86,735Commercial
      - other
                          
                          
                          33,104
                          
                          
                          
                          29,129
                          
                          
                          
                          22,169
                          
                          
                          
                          29,284
                          
                          
                          
                          33,470Tax
      exempt
                          
                          
                          18,920
                          
                          
                          
                          10,899
                          
                          
                          
                          3,264
                          
                          
                          
                          3,840
                          
                          
                          
                          3,629Real
      estate (primarily residential mortgage loans)
                          
                          
                          136,288
                          
                          
                          
                          130,865
                          
                          
                          
                          86,208
                          
                          
                          
                          92,840
                          
                          
                          
                          92,408Consumer
      loans
                          
                          
                          15,291
                          
                          
                          
                          16,712
                          
                          
                          
                          18,728
                          
                          
                          
                          18,467
                          
                          
                          
                          20,823Total
      Gross Loans
                          
                          $
                          409,698
                          
                          
                          $
                          378,408
                          
                          
                          $
                          254,042
                          
                          
                          $
                          237,361
                          
                          
                          $
                          237,065Less:
      Unearned income andunamortized loan fees net of costs
                          
                          
                          1,331
                          
                          
                          
                          1,805
                          
                          
                          
                          2,285
                          
                          
                          
                          2,768
                          
                          
                          
                          3,265Total
      Loans, net of unearned income
                          
                          $
                          408,367
                          
                          
                          $
                          376,603
                          
                          
                          $
                          251,757
                          
                          
                          $
                          234,593
                          
                          
                          $
                          233,800
  INVESTMENT
SECURITIES
 
 The
Corporation uses investment securities to not only generate interest and
dividend revenue, but also to help manage interest rate risk and to provide
liquidity to meet operating cash needs.
 
 The
investment portfolio has been allocated between securities available for sale
and securities held to maturity. No investment securities were established in a
trading account. Available for sale securities decreased $1,346,000, or 0.6% to
$240,175,000 after increasing to $241,521,000 in 2007, a 1.9% increase from
2006. At December 31, 2008 the net unrealized loss, net of the tax effect, on
these securities was $4,671,000 and is included in stockholders’ equity as
accumulated other comprehensive loss. At December 31, 2007, accumulated other
comprehensive income, net of tax effect, amounted to a loss of $166,000. In
2008, held to maturity securities decreased $1,548,000, or 34.1% to $2,990,000
after decreasing $2,391,000, or 34.5% in 2007. Table 7 provides data on the
carrying value of our investment portfolio on the dates indicated. The vast
majority of investment security purchases are allocated as available for sale.
This provides the Corporation with increased flexibility should  there
be a need or desire to liquidate an investment security.
  21
  The
investment portfolio includes U.S. Government Corporations and Agencies,
corporate obligations, mortgage backed securities, state and municipal
securities, and other debt securities. In addition, the investment portfolio
includes restricted equity securities consisting primarily of common stock
investments in the Federal Reserve Bank and the Federal Home Loan Bank.
Marketable equity securities consists of common stock investments in other
commercial banks and bank holding companies.
 
 Securities
available for sale may be sold as part of the overall asset and liability
management process. Realized gains and losses are reflected in the results of
operations on our statements of income. The investment portfolio does not
contain any structured notes, step-up bonds, or any off-balance sheet
derivatives.
 
 During
2008, interest bearing deposits in other banks decreased to $6,000 from $89,000
in 2007. Interest bearing deposits in other banks are generally kept relatively
low as funds were invested in marketable securities to maximize income while
still addressing liquidity needs.
 
 Table
7  —  Carrying Value of Investment Securities
 
 (Amounts
in thousands)
 December 31,2008
                  
                  
                  2007
                  
                  
                  2006Available
                  
                  
                  Held
      to
                  
                  
                  Available
                  
                  
                  Held
      to
                  
                  
                  Available
                  
                  
                  Held
      tofor Sale
                  
                  
                  Maturity
                  
                  
                  for Sale
                  
                  
                  Maturity
                  
                  
                  for Sale
                  
                  
                  MaturityU.
      S. Government Corporations and Agencies
                  
                  $
                  78,344
                  
                  
                  $
                  176
                  
                  
                  $
                  149,607
                  
                  
                  $
                  2,191
                  
                  
                  $
                  153,211
                  
                  
                  $
                  4,205State
      and Municipal
                  
                  
                  133,461
                  
                  
                  
                  2,814
                  
                  
                  
                  74,359
                  
                  
                  
                  2,347
                  
                  
                  
                  73,456
                  
                  
                  
                  2,724Corporate
                  
                  
                  19,781
                  
                  
                  
                  —
                  
                  
                  
                  8,530
                  
                  
                  
                  —
                  
                  
                  
                  2,019
                  
                  
                  
                  —Marketable
      Equity Securities
                  
                  
                  1,911
                  
                  
                  
                  —
                  
                  
                  
                  2,916
                  
                  
                  
                  —
                  
                  
                  
                  3,711
                  
                  
                  
                  —Restricted
      Equity Securities
                  
                  
                  6,678
                  
                  
                  
                  —
                  
                  
                  
                  6,109
                  
                  
                  
                  —
                  
                  
                  
                  4,612
                  
                  
                  
                  —Total
      Investment Securities
                  
                  $
                  240,175
                  
                  
                  $
                  2,990
                  
                  
                  $
                  241,521
                  
                  
                  $
                  4,538
                  
                  
                  $
                  237,009
                  
                  
                  $
                  6,929
 
 ALLOWANCE
FOR LOAN LOSSES
 
 The
allowance for loan losses constitutes the amount available to absorb losses
within the loan portfolio. As of December
31, 2008, the allowance for loan losses was $5,195,000 as compared to $5,046,000
and $3,671,000 as of December 31, 2007 and 2006, respectively. The allowance for
loan losses as of December 31, 2007 included $1,282,000 acquired through the
Pocono Community Bank acquisition. The allowance for loan losses is established
through a provision for loan losses charged to expenses. Loans are charged
against the allowance for possible loan losses when management believes that the
collectibility of the principal is unlikely. The risk characteristics of the
loan portfolio are managed through the various control processes, including
credit evaluations of individual borrowers, periodic reviews, and
diversification by industry. Risk is further mitigated through the application
of lending procedures such as the holding of adequate collateral and the
establishment of contractual guarantees.
 
 Management
performs a quarterly analysis to determine the adequacy of the allowance for
loan losses. The methodology in determining adequacy incorporates specific and
general allocations together with a risk/loss analysis on various segments of
the portfolio according to an internal loan review process. This assessment
results in an allocated allowance. Management maintains its loan review and loan
classification standards consistent with those of its regulatory supervisory
authority.
 
 Management
feels based upon its methodology, that the allowance for loan losses is adequate
to cover foreseeable future losses. Table 8 contains an analysis of our
Allowance for Loan Losses indicating charge-offs and recoveries by the year and
annual additional provisions charged to operations. In 2008, net charge-offs as
a percentage of average loans were .14% compared to .02% in 2007 and .21%
in  2006. Net charge-offs amounted to $551,000 in 2008 compared to
$57,000 in 2007 and $505,000 in 2006, respectively. The increase in net
charge-offs in 2008 relates primarily to one commercial real estate loan which,
as a result of a bankruptcy and foreclosure, was liquidated by the Bank for less
than the principal loan balance.
  22
  Table
8  —  Analysis of Allowance for Loan
Losses
 
 (Amounts
      in thousands)
                  
                  Years Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Balance
      at beginning of period Charge-offs:
                  
                  $
                  5,046
                  
                  
                  $
                  3,671
                  
                  
                  $
                  3,676
                  
                  
                  $
                  3,828
                  
                  
                  $
                  3,524Commercial,
      financial, and agricultural
                  
                  
                  44
                  
                  
                  
                  12
                  
                  
                  
                  493
                  
                  
                  
                  338
                  
                  
                  
                  1,209Real
      estate
                  
                  
                  633
                  
                  
                  
                  138
                  
                  
                  
                  183
                  
                  
                  
                  497
                  
                  
                  
                  132Consumer
                  
                  
                  62
                  
                  
                  
                  86
                  
                  
                  
                  110
                  
                  
                  
                  98
                  
                  
                  
                  143739
                  
                  
                  
                  236
                  
                  
                  
                  786
                  
                  
                  
                  933
                  
                  
                  
                  1,484Recoveries:Commercial,
      financial, and agricultural
                  
                  
                  154
                  
                  
                  
                  135
                  
                  
                  
                  228
                  
                  
                  
                  —
                  
                  
                  
                  —Real
      estate
                  
                  
                  6
                  
                  
                  
                  11
                  
                  
                  
                  4
                  
                  
                  
                  1
                  
                  
                  
                  18Consumer
                  
                  
                  28
                  
                  
                  
                  33
                  
                  
                  
                  49
                  
                  
                  
                  30
                  
                  
                  
                  20188
                  
                  
                  
                  179
                  
                  
                  
                  281
                  
                  
                  
                  31
                  
                  
                  
                  38Net
      charge-offs
                  
                  
                  551
                  
                  
                  
                  57
                  
                  
                  
                  505
                  
                  
                  
                  902
                  
                  
                  
                  1,446Additions
      charged to operations
                  
                  
                  700
                  
                  
                  
                  150
                  
                  
                  
                  500
                  
                  
                  
                  750
                  
                  
                  
                  1,750Allowance
      purchased
                  
                  
                  —
                  
                  
                  
                  1,282
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —Balance
      at end of period
                  
                  $
                  5,195
                  
                  
                  $
                  5,046
                  
                  
                  $
                  3,671
                  
                  
                  $
                  3,676
                  
                  
                  $
                  3,828Ratio
      of net charge-offs during the period to average loans outstanding during
      the period
                  
                  
                  .14
                  %
                  
                  
                  .02
                  %
                  
                  
                  .21
                  %
                  
                  
                  .39
                  %
                  
                  
                  .62
                  %Allowance
      for loan losses to average loans outstanding during the
    period
                  
                  
                  1.33
                  %
                  
                  
                  1.82
                  %
                  
                  
                  1.50
                  %
                  
                  
                  1.58
                  %
                  
                  
                  1.64
                  %
 
 It is the
policy of management and the Corporation’s Board of Directors to provide for
losses on both identified  and unidentified losses inherent in its
loan portfolio. A provision for loan losses is charged to operations based upon
an evaluation of the potential losses in the loan portfolio. This evaluation
takes into account such factors  as portfolio concentrations,
delinquency, trends, trends of non-accrual and classified loans, economic
conditions, and other relevant factors.
 
 The loan
review process which is conducted quarterly, is an integral part of our
evaluation of the loan portfolio. A detailed quarterly analysis to determine the
adequacy of the Corporation’s allowance for loan losses is reviewed by our Board
of Directors.
 
 With our
manageable level of net charge-offs and the additions to the reserve from our
provision out of operations, the allowance for loan losses as a percentage of
average loans amounted to 1.33% in 2008, 1.82% to 2007, and 1.50% in
2006.
 
 Table 9
sets forth the allocation of the Bank’s allowance for loan losses by loan
category and the percentage of loans in each category to total loans receivable
at the dates indicated. The portion of the allowance for loan losses allocated
to each loan category does not represent the total available for future losses
that may occur within the loan category, since the total loan loss allowance is
a valuation reserve applicable to the entire loan portfolio.
 
 Table
9  —  Allocation of Allowance for Loan Losses
 
 (Amounts
      in thousands)
                  
                  December 31,2008
                  
                  
                  
                  %*
                  
                  
                  2007
                  
                  
                  
                  %*
                  
                  
                  2006
                  
                  
                  
                  %*
                  
                  
                  2005
                  
                  
                  
                  %*
                  
                  
                  2004
                  
                  
                  
                  %*Commercial,
      financial, and agricultural
                  
                  $
                  721
                  
                  
                  
                  12.7
                  
                  
                  $
                  1,116
                  
                  
                  
                  22.8
                  
                  
                  $
                  674
                  
                  
                  
                  19.7
                  
                  
                  $
                  906
                  
                  
                  
                  25.2
                  
                  
                  $
                  858
                  
                  
                  
                  14.3Real
      estate - mortgage
                  
                  
                  3,641
                  
                  
                  
                  84.1
                  
                  
                  
                  3,680
                  
                  
                  
                  75.1
                  
                  
                  
                  2,613
                  
                  
                  
                  76.1
                  
                  
                  
                  2,521
                  
                  
                  
                  70.2
                  
                  
                  
                  2,594
                  
                  
                  
                  77.1Consumer
      and other loans
                  
                  
                  207
                  
                  
                  
                  3.2
                  
                  
                  
                  103
                  
                  
                  
                  2.1
                  
                  
                  
                  145
                  
                  
                  
                  4.2
                  
                  
                  
                  164
                  
                  
                  
                  4.6
                  
                  
                  
                  308
                  
                  
                  
                  8.6Unallocated
                  
                  
                  626
                  
                  
                  
                  N/A
                  
                  
                  
                  147
                  
                  
                  
                  N/A
                  
                  
                  
                  239
                  
                  
                  
                  N/A
                  
                  
                  
                  85
                  
                  
                  
                  N/A
                  
                  
                  
                  68
                  
                  
                  
                  N/A$
                  5,195
                  
                  
                  
                  100.0
                  
                  
                  $
                  5,046
                  
                  
                  
                  100.0
                  
                  
                  $
                  3,671
                  
                  
                  
                  100.0
                  
                  
                  $
                  3,676
                  
                  
                  
                  100.0
                  
                  
                  $
                  3,828
                  
                  
                  
                  100.0
 
 
 *Percentage
of loans in each category to total loans in the Allowance for Loan Loss
Analysis.
  23
  NON-PERFORMING
ASSETS
 
 Table 10
details the Corporation's non-performing assets at the dates
indicated.
 
 Non-accrual
loans are generally delinquent on which principal or interest is past-due
approximately 90 days or more, depending upon the type of credit and the
collateral. When a loan is placed on non-accrual status, any unpaid interest is
charged against income. Restructured loans are loans where the borrower has been
granted a concession in the interest rate or payment amount because of financial
problems. Foreclosed assets held for sale represents property acquired through
foreclosure, or considered to be an in-substance foreclosure.
 
 The total
of non-performing assets decreased to $1,761,000 as of December 31, 2008, as
compared to $3,458,000 as of December 31, 2007. Non-accrual and restructured
loans decreased to $1,718,000 in 2008 from $3,208,000 in 2007. Foreclosed assets
decreased to $28,000 in 2008 from $65,000 in 2007. Loans past-due 90 days or
more and still accruing decreased to $15,000 in 2008 from $185,000 in 2007.
Non-performing assets to period end loans foreclosed assets was 0.43% in 2008,
0.92% in 2007, and 1.14% in 2006. Total non-performing assets to total assets
also declined to 0.25% in 2008 from 0.51% and 0.55% in 2007 and 2006,
respectively. Our allowance for loan losses to total non-performing assets
increased to 295.0% in 2008 from 145.9% in 2007. While asset quality is a
priority, the corporation retains a full-time loan review officer to closely
track and monitor overall loan quality.
 
 Improving
loan quality is a priority, and we actively work with borrowers to resolve
credit problems. Excluding the assets disclosed in Table 10, management is not
aware of any information about borrowers' possible credit problems, which cause
serious doubt as to their ability to comply with present loan repayment
terms.
 
 Should
the economic climate no longer continue to be stable or begin to deteriorate,
borrowers may experience difficulty, and the level of non-performing loans and
assets, charge-offs and delinquencies could rise and possibly require additional
increases in our allowance for loan losses.
 
 In
addition, regulatory authorities, as an integral part of their examinations,
periodically review the allowance for possible loan and lease losses. They may
require additions to allowances based upon their judgements about information
available to them at the time of examination.
 
 Interest
income received on non-performing loans in 2008 and 2007 was $95,000 and
$144,000, respectively. Interest income, which would have been recorded on these
loans under the original terms in 2008 and 2007 was $149,000 and $175,000,
respectively. At December 31, 2008, the Corporation had no outstanding
commitments to advance additional funds with respect to these non-performing
loans.
 
 A
concentration of credit exists when the total amount of loans to borrowers, who
are engaged in similar activities that are similarly impacted by economic or
other conditions, exceed 10% of total loans. As of December 31, 2008, 2007 and
2006, management is of the opinion that there were no loan concentrations
exceeding 10% of total loans.
 
 Table
10  —  Non-Performing Assets
 
 (Amounts
      in thousands)
                  
                  December 31,2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Non-accrual
      and restructured loans
                  
                  $
                  1,718
                  
                  
                  $
                  3,208
                  
                  
                  $
                  1,704
                  
                  
                  $
                  2,069
                  
                  
                  $
                  3,405Foreclosed
      assets
                  
                  
                  28
                  
                  
                  
                  65
                  
                  
                  
                  41
                  
                  
                  
                  397
                  
                  
                  
                  6Loans
      past-due 90 days or more and still accruing
                  
                  
                  15
                  
                  
                  
                  185
                  
                  
                  
                  1,135
                  
                  
                  
                  64
                  
                  
                  
                  69Total
      non-performing assets
                  
                  $
                  1,761
                  
                  
                  $
                  3,458
                  
                  
                  $
                  2,880
                  
                  
                  $
                  2,530
                  
                  
                  $
                  3,480Non-performing
      assets to period-end loans and foreclosed assets
                  
                  
                  0.43
                  %
                  
                  
                  0.92
                  %
                  
                  
                  1.14
                  %
                  
                  
                  1.08
                  %
                  
                  
                  1.49
                  %Total
      non-performing assets to total assets
                  
                  
                  0.25
                  %
                  
                  
                  0.51
                  %
                  
                  
                  0.55
                  %
                  
                  
                  0.49
                  %
                  
                  
                  0.70
                  %Total
      allowance for loan losses to total non-performing assets
                  
                  
                  295.0
                  %
                  
                  
                  145.9
                  %
                  
                  
                  127.5
                  %
                  
                  
                  145.3
                  %
                  
                  
                  110.0
                  %
  24
  Real
estate mortgages comprise 83.8% of the loan portfolio as of December 31, 2008,
down from 85.4% in 2007. Real estate mortgages consist of both residential and
commercial real estate loans. The real estate loan portfolio is well diversified
in terms of borrowers, collateral, interest rates, and maturities. Also, the
real estate loan portfolio has a mix of both fixed rate and adjustable rate
mortgages. The real estate loans are concentrated primarily in our marketing
area and are subject to risks associated with the local economy.
 
 DEPOSITS
AND OTHER BORROWED FUNDS
 
 Consumer
and commercial retail deposits are attracted primarily by First Keystone’s
subsidiary bank's fourteen full service office locations. The Bank offers a
broad selection of deposit products and continually evaluates its interest rates
and fees on deposit products. The Bank regularly reviews competing financial
institutions interest rates along with prevailing market rates, especially when
establishing interest rates on certificates of deposit.
 
 Deposits
increased by $11,592,000, or a 2.4% increase when comparing December 31, 2008 to
December 31, 2007. This increase compares to a deposit increase of $109,021 in
2007 and an increase of 28.4% in 2007. Much of the deposit increase in 2007
relates to the Pocono Community Bank acquisition.
 
 During
2008, the Corporation experienced a deposit increase in interest bearing
deposits. Non-interest bearing deposits amounted to $58,178,000 as of December
31, 2008, a decrease of $666,000 or 1.1% from 2007. Interest bearing deposits
amounted to $446,455,000 as of December 31, 2008, an increase of $12,258,000, or
2.83% over 2007.
 
 During
2008, the Corporation increased its reliance on borrowings. Short-term
borrowings amounted to $55,332,000 as of year-end 2008, an increase of
$7,983,000 from 2007. Long-term borrowings increased $15,887,000 in 2008 to
$82,062,000 as of December 31, 2008. Total borrowings were $137,394,000 as of
December 31, 2008, compared to $113,524,000 on December 31, 2007. Short-term
borrowings are comprised of federal funds purchased, securities sold under
agreements to repurchase, U.S. Treasury demand notes, and short-term borrowings
from the Federal Home Loan Bank (FHLB).
 
 Long-term
borrowings are typically FHLB term borrowings with a maturity of one year or
more. Short-term borrowings from the Federal Home Loan Bank are commonly used to
offset seasonal fluctuations in deposits. In connection with FHLB borrowings and
securities sold under agreements to repurchase, the Corporation maintains
certain eligible assets as collateral.
 
 CAPITAL
STRENGTH
 
 Normal
increases in capital are generated by net income, less cash dividends paid out.
Also, the net unrealized gains or losses on investment securities
available-for-sale, net of taxes, referred to as accumulated other comprehensive
income may increase or decrease total equity capital. The total net decrease in
capital was $1,777,000 in 2008 after an increase of $17,537,000 in 2007. Much of
the increase in equity capital in 2007 relates to the Pocono Community Bank
acquisition. The accumulated other comprehensive income amounted to $(4,671,000)
in 2008 and $(166,000) in 2007. One factor which also decreased total equity
capital in 2008 and 2007 relates to stock repurchase. The Corpor­ation had
247,641 shares of common stock as of December 31, 2008, and 247,691 shares in
2007, at a cost of $6,240,000 and $6,242,000, respectively as treasury
stock.
 
 Return on
equity (ROE) is computed by dividing net income by average stockholders’
equity.  This ratio was 10.72% for 2008, 10.48% for 2007, and 11.76%
for 2006. Refer to Performance Ratios on page 14 — Selected Financial Data for a
more expanded listing of the ROE.
 
 Adequate
capitalization of banks and bank holding companies is required and monitored by
regulatory authorities. Table 11 reflects risk-based capital ratios and the
leverage ratio for our Corporation and Bank. The Corpor­ation's leverage
ratio was 7.59% at December 31, 2008, and 7.96% at December 31,
2007.
 
 The
Corporation has consistently maintained regulatory capital ratios at or above
the “well capitalized” standards. For additional information on capital ratios,
see page 26 - Corporations Capital Ratios or Table 11 — Capital Ratios. The
risk-based capital ratios for both the Corporation and the Bank, although down
remained strong. The risk-based capital calculation assigns various levels of
risk to different categories of bank assets, requiring higher levels of capital
for assets with more risk. Also measured in the risk-based capital ratio is
credit risk exposure associated with off-balance sheet contracts and
commitments.
  25
 
 Table
11  —  Capital Ratios
 
 December 31, 2008
                  
                  
                  December 31, 2007Corporation
                  
                  
                  Bank
                  
                  
                  Corporation
                  
                  
                  BankRisk-Based
      Capital:Tier
      I risk-based capital ratio
                  
                  
                  10.95
                  %
                  
                  
                  11.97
                  %
                  
                  
                  11.86
                  %
                  
                  
                  13.10
                  %Total
      risk-based capital ratio (Tier 1 and Tier 2)
                  
                  
                  12.02
                  %
                  
                  
                  13.03
                  %
                  
                  
                  13.06
                  %
                  
                  
                  14.28
                  %Leverage
      Ratio:Tier
      I capital to average assets
                  
                  
                  7.59
                  %
                  
                  
                  8.45
                  %
                  
                  
                  7.96
                  %
                  
                  
                  9.00
                  %
  LIQUIDITY
MANAGEMENT
 
 Effective
liquidity management ensures that the cash flow requirements of depositors and
borrowers, as well as the operating cash needs of the Corporation, are
met.
 
 Liquidity
is needed to provide the funding requirements of depositors withdrawals, loan
growth, and other operational needs. Asset liquidity is provided by investment
securities maturing in one year or less, other short-term investments, federal
funds sold, and cash and due from banks. At year-end 2008, cash and due from
banks and interest-bearing deposits in other banks totaled $9,951,000 as
compared to $9,975,000 at year-end 2007. Additionally, maturing loans and
repayment of loans are another source of asset liquidity.
 
 Liability
liquidity is accomplished by maintaining a core deposit base, acquired by
attracting new deposits and retaining maturing deposits.  Also,
short-term borrowings provide funds to meet liquidity.
 
 Management
feels its current liquidity position is satisfactory given the fact that the
Corporation has a very stable core deposit base which has increased annually.
Secondly, our loan payments and principal paydowns on our mortgage backed
securities provide a steady source of funds. Also, short-term investments and
maturing investments represent additional sources of liquidity.
 
 Finally,
the Corporation’s subsidiary bank does have access to funds on a short-term
basis from the Federal Reserve Bank discount window. Also, Fed funds can be
purchased by means of a borrowing line at the Atlantic Central Bankers Bank. The
Corporation has indirect access to the capital markets through its membership in
the Federal Home Loan Bank. Advances on borrowings, both short-term and
long-term, are available to help address any liquidity needs.
 
 FORWARD
LOOKING STATEMENTS
 
 The
sections that follow, Market Risk and Asset/Liability Management contain certain
forward looking statements. These forward looking statements involve significant
risks and uncertainties, including changes in economic and financial market
conditions.  Although First Keystone Corporation believes that the
expectations reflected in such forward looking statements are reasonable, actual
results may differ materially.
 
 MARKET
RISK
 
 Market
risk is the risk of loss arising from adverse changes in the fair value of
financial instruments due to changes in interest rates, exchange rates and
equity prices.  First Keystone Corporation’s market risk is composed
primarily of interest rate risk. The Corporation’s interest rate risk results
from timing differences in the repricing of assets, liabilities, off-balance
sheet instruments, and changes in relationships between ratio indices and the
potential exercise of explicit or embedded options.
 
 Increases
in the level of interest rates also may adversely affect the fair value of the
Corporation’s securities and other earning assets. Generally, the fair value of
fixed-rate instruments fluctuates inversely with changes in interest rates. As a
result, increases in interest rates could result in decreases in the fair value
of the Corporation’s interest-earning assets, which could adversely affect the
Corpor­ation’s results of operations if sold, or, in the case of interest
earning assets classified as available for sale, the Corpor­ation’s
stockholders’ equity, if retained. Under The Financial Accounting Standards
Board (FASB) Statement 115, changes in the unrealized gains and losses, net of
taxes, on securities classified as available for sale will be reflected in the
Corporation’s stockholders’ equity. The Corporation does not own any trading
assets.
  26
 
 Asset/Liability
Management
 
 The
principal objective of asset liability management is to manage the sensitivity
of the net interest margin to potential movements in interest rates and to
enhance profitability through returns from managed levels of interest rate risk.
The Corporation actively manages the interest rate sensitivity of its assets and
liabilities. Table 12 presents an interest sensitivity analysis of assets and
liabilities as of December 31, 2008. Several techniques are used for measuring
interest rate sensitivity. Interest rate risk arises from the mismatches in the
repricing of assets and liabilities within a given time period, referred to as a
rate sensitivity gap. If more assets than liabilities mature or reprice within
the time frame, the Corporation is asset sensitive. This position would
contribute positively to net interest income in a rising rate environment.
Conversely, if more liabilities mature or reprice, the Corporation is liability
sensitive. This position would contribute positively to net interest income in a
falling rate environment.
 
 Limitations
of interest rate sensitivity gap analysis as illustrated in Table 12
include:  a) assets and liabilities which contractually reprice within
the same period may not, in fact, reprice at the same time or to the same
extent; b) changes in market interest rates do not affect all assets and
liabilities to the same extent or at the same time, and c) interest rate
sensitivity gaps reflect the Corporation’s position on a single day (December
31, 2008 in the case of the following schedule) while the Corporation
continually adjusts its interest sensitivity throughout the year. The
Corporation’s cumulative gap at one year indicates the Corporation is liability
sensitive.
  Table
12  —  Interest Rate Sensitivity Analysis
 
 (Amounts
      in thousands)December 31, 2008One
                    
                    
                    1
      - 5
                    
                    
                    Beyond
                    
                    
                    Not
      RateYear
                    
                    
                    Years
                    
                    
                    5 Years
                    
                    
                    Sensitive
                    
                    
                    TotalAssets
                    
                    $
                    165,317
                    
                    
                    $
                    230,204
                    
                    
                    $
                    279,741
                    
                    
                    $
                    39,636
                    
                    
                    $
                    714,898Liabilities/Stockholders
      Equity
                    
                    
                    283,837
                    
                    
                    
                    265,776
                    
                    
                    
                    93,713
                    
                    
                    
                    71,572
                    
                    
                    
                    714,898Interest
      Rate Sensitivity Gap
                    
                    
                    (118,520
                    )
                    
                    
                    (35,572
                    )
                    
                    
                    186,028
                    
                    
                    
                    (31,936
                    )Cumulative
      Gap
                    
                    
                    (118,520
                    )
                    
                    
                    (154,092
                    )
                    
                    
                    31,936
  Earnings
at Risk
 
 The
Bank’s Asset/Liability Committee (ALCO) is responsible for reviewing the
interest rate sensitivity position and establishing policies to monitor and
limit exposure to interest rate risk. The guidelines established by ALCO are
reviewed by the Corporation’s Board of Directors. The Corporation recognizes
that more sophisticated tools exist for measuring the interest rate risk in the
balance sheet beyond interest rate sensitivity gap. Although the Corporation
continues to measure its interest rate sensitivity gap, the Corporation utilizes
additional modeling for interest rate risk in the overall balance sheet.
Earnings at risk and economic values at risk are analyzed.
 
 Earnings
simulation modeling addresses earnings at risk and net present value estimation
addresses economic value at risk. While each of these interest rate risk
measurements has limitations, taken together they represent a reasonably
comprehensive view of the magnitude of interest rate risk in the
Corporation.
 
 Earnings
Simulation Modeling
 
 The
Corporation’s net income is affected by changes in the level of interest
rates.  Net income is also subject to changes in the shape of the
yield curve.  For example, a flattening of the yield curve would
result in a decline in earnings due to the compression of earning asset yields
and increased liability rates, while a steepening would result in increased
earnings as earning asset yields widen.
  27
  Earnings
simulation modeling is the primary mechanism used in assessing the impact of
changes in interest rates on net interest income. The model reflects
management's assumptions related to asset yields and rates paid on liabilities,
deposit sensitivity, size and composition of the balance sheet. The assumptions
are based on what management believes at that time to be the most likely
interest rate environment. Earnings at risk is the change in net interest income
from a base case scenario under an increase and decrease of 200 basis points in
the interest rate earnings simulation model.
 
 Table 13
presents an analysis of the changes in net-interest income and net present value
of the balance sheet resulting from an increase or decrease of two percentage
points (200 basis points) in the level of interest rates. The calculated
estimates of change in net interest income and net present value of the balance
sheet are compared to current limits approved by ALCO and the Board of
Directors. The earnings simulation model projects net-interest income would
increase by approximately 4.1% if rates fell by two percentage points over one
year. The model projects a decrease of approximately 11.6% in net-interest
income if rates rise by two percentage points over one year. Both of these
forecasts are within the one year policy guidelines.
 
 Net
Present Value Estimation
 
 The net
present value measures economic value at risk and is used for helping to
determine levels of risk at a point in time present in the balance sheet that
might not be taken into account in the earnings simulation model. The net
present value of the balance sheet is defined as the discounted present value of
asset cash flows minus the discounted present value of liability cash flows. At
year-end 2008, a 200 basis point immediate decrease in rates is estimated to
increase net present value by 33.0%. Additionally, net present value is
projected to decrease by 42.0% if rates increase immediately by 200 basis
points. The +2% scenario slightly exceeds policy limits of 40%.
 
 The
computation of the effects of hypothetical interest rate changes are based on
many assumptions. They should not be relied upon solely as being indicative of
actual results, since the computations do not contemplate actions management
could undertake in response to changes in interest rates.
 
 Table
13  —  Effect of Change in Interest Rates
 Projected ChangeEffect
      on Net Interest Income1-year
      Net Income simulation Projection–200
      bp Shock vs Stable Rate
                    
                    
                    4.1
                    %+200
      bp Shock vs Stable Rate
                    
                    
                    (11.6
                    )%Effect
      on Net Present Value of Balance SheetStatic
      Net Present Value Change–200
      bp Shock vs Stable Rate
                    
                    
                    33.0
                    %+200
      bp Shock vs Stable Rate
                    
                    
                    (42.0
                    )%
  MARKET
PRICE/DIVIDEND HISTORY
 
 As of
December 31, 2008, the corporation had 5,440,126 shares of $2.00 par value
common stock out­standing held by shareholders of record. First Keystone
Corporation’s common stock is quoted on the Over The Counter (OTC) Bulletin
Board under the symbol “FKYS.OB”.
 
 Table 14
reports the highest and lowest per share prices known to the Corporation and the
dividends paid during the periods indicated. The market prices and dividend paid
have been adjusted to reflect a 5% stock dividend paid December 5, 2006. These
prices do not necessarily reflect any dealer or retail markup, markdown or
commission.
  28
  Table
14  —  Market Price/Dividend History
 
 2008
                                          
                                          
                                          2007
                                          
                                          
                                          2006Common
      Stock
                                          
                                          
                                          Dividends
                                          
                                          
                                          Common
      Stock
                                          
                                          
                                          Dividends
                                          
                                          
                                          Common
      Stock
                                          
                                          
                                          DividendsHigh/Low
                                          
                                          
                                          Paid
                                          
                                          
                                          High/Low
                                          
                                          
                                          Paid
                                          
                                          
                                          High/Low
                                          
                                          
                                          PaidFirst
      Quarter
                                          
                                          $18.00/$15.25
                                          
                                          
                                          $
                                          .22
                                          
                                          
                                          $19.00/$17.50
                                          
                                          
                                          $
                                          .22
                                          
                                          
                                          $19.91/$18.57
                                          
                                          
                                          $
                                          .21Second
      Quarter
                                          
                                          $18.00/$14.25
                                          
                                          
                                          
                                          .22
                                          
                                          
                                          $21.75/$17.90
                                          
                                          
                                          
                                          .22
                                          
                                          
                                          $19.05/$17.43
                                          
                                          
                                          
                                          .21Third
      Quarter
                                          
                                          $18.00/$15.50
                                          
                                          
                                          
                                          .22
                                          
                                          
                                          $19.25/$17.00
                                          
                                          
                                          
                                          .22
                                          
                                          
                                          $19.33/$16.81
                                          
                                          
                                          
                                          .21Fourth
      Quarter
                                          
                                          $16.00/$13.50
                                          
                                          
                                          
                                          .23
                                          
                                          
                                          $18.25/$15.80
                                          
                                          
                                          
                                          .22
                                          
                                          
                                          $19.20/$17.29
                                          
                                          
                                          
                                          .22
  Table
15  —  Quarterly Results of Operations
(Unaudited)
  (Amounts
in thousands, except per share)
 
 Three
      Months Ended2008
                      
                      March
      31
                      
                      
                      June
      30
                      
                      
                      September
      30
                      
                      
                      December
      31Interest
      income
                      
                      $
                      9,351
                      
                      
                      $
                      9,267
                      
                      
                      $
                      9,491
                      
                      
                      $
                      9,529Interest
      expense
                      
                      
                      4,853
                      
                      
                      
                      4,546
                      
                      
                      
                      4,399
                      
                      
                      
                      4,318Net
      interest income
                      
                      $
                      4,498
                      
                      
                      $
                      4,721
                      
                      
                      $
                      5,092
                      
                      
                      $
                      5,211Provision
      for loan losses
                      
                      
                      50
                      
                      
                      
                      75
                      
                      
                      
                      75
                      
                      
                      
                      500Other
      non-interest income
                      
                      
                      1,105
                      
                      
                      
                      998
                      
                      
                      
                      1,130
                      
                      
                      
                      813Non-interest
      expense
                      
                      
                      3,450
                      
                      
                      
                      3,348
                      
                      
                      
                      3,446
                      
                      
                      
                      3,679Income
      before income taxes
                      
                      $
                      2,103
                      
                      
                      $
                      2,296
                      
                      
                      $
                      2,701
                      
                      
                      $
                      1,845Income
      taxes
                      
                      
                      381
                      
                      
                      
                      410
                      
                      
                      
                      474
                      
                      
                      
                      129Net
      income
                      
                      $
                      1,722
                      
                      
                      $
                      1,886
                      
                      
                      $
                      2,227
                      
                      
                      $
                      1,716Per
      share
                      
                      $
                      .32
                      
                      
                      $
                      .34
                      
                      
                      $
                      .41
                      
                      
                      $
                      .32
 
 2007
                  
                  March 31
                  
                  
                  June 30
                  
                  
                  September 30
                  
                  
                  December 31Interest
      income
                  
                  $
                  7,407
                  
                  
                  $
                  7,550
                  
                  
                  $
                  7,830
                  
                  
                  $
                  9,113Interest
      expense
                  
                  
                  4,086
                  
                  
                  
                  4,175
                  
                  
                  
                  4,469
                  
                  
                  
                  5,056Net
      interest income
                  
                  $
                  3,321
                  
                  
                  $
                  3,375
                  
                  
                  $
                  3,361
                  
                  
                  $
                  4,057Provision
      for loan losses
                  
                  
                  50
                  
                  
                  
                  75
                  
                  
                  
                  25
                  
                  
                  
                  0Other
      non-interest income
                  
                  
                  953
                  
                  
                  
                  1,042
                  
                  
                  
                  973
                  
                  
                  
                  1,201Non-interest
      expense
                  
                  
                  2,491
                  
                  
                  
                  2,669
                  
                  
                  
                  2,430
                  
                  
                  
                  3,025Income
      before income taxes
                  
                  $
                  1,733
                  
                  
                  $
                  1,673
                  
                  
                  $
                  1,879
                  
                  
                  $
                  2,233Income
      taxes
                  
                  
                  299
                  
                  
                  
                  289
                  
                  
                  
                  338
                  
                  
                  
                  465Net
      income
                  
                  $
                  1,434
                  
                  
                  $
                  1,384
                  
                  
                  $
                  1,541
                  
                  
                  $
                  1,768Per
      share
                  
                  $
                  .32
                  
                  
                  $
                  .30
                  
                  
                  $
                  .34
                  
                  
                  $
                  .35
  ITEM
7A.     QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT
MARKET RISK
 
 Information
with respect to quantitative and qualitative disclosures about market risk is
included in the information under Management’s Discussion and Analysis in Item 7
hereof.
  29
  ITEM
8.        FINANCIAL STATEMENTS AND
SUPPLEMENTARY DATA
 
 REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM
 
 BOARD OF
DIRECTORS AND STOCKHOLDERS OF FIRST KEYSTONE CORPORATION:
 
 We have
audited the accompanying consolidated balance sheets of First Keystone
Corporation and Subsidiary as of December 31, 2008 and 2007, and the related
consolidated statements of income, changes in stockholders’ equity, and cash
flows for each of the years in the three-year period ended December 31,
2008.  These consolidated financial statements are the responsibility
of the Corporation’s management.  Our responsibility is to express an
opinion on these consolidated financial statements based on our
audits.
 
 We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
consolidated financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the consolidated financial
statements.  An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall consolidated financial statement
presentation.  We believe that our audits provide a reasonable basis
for our opinion.
 
 In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the consolidated financial position of First Keystone
Corporation and Subsidiary as of December 31, 2008 and 2007, and the
consolidated results of their operations and their cash flows for each of the
years in the three-year period ended December 31, 2008, in conformity with
accounting principles generally accepted in the United States of
America.
 
 We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States) the effectiveness of First Keystone Corporation
and Subsidiary’s internal control over financial reporting as of
 December
31, 2008, based on criteria established in Internal Control-Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO) and our report dated March 9, 2009, expressed an
unqualified opinion thereon.
 
 /s/ J. H. Williams & Co.,
      LLPJ.
      H. Williams & Co., LLP
  Kingston,
Pennsylvania
 March 9,
2009
  30
  FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 CONSOLIDATED
BALANCE SHEETS
  (Amounts
      in thousands)
                  
                  December 31,2008
                  
                  
                  2007ASSETSCash
      and due from banks
                  
                  $
                  9,945
                  
                  
                  $
                  9,886Interest-bearing
      deposits in other banks
                  
                  
                  6
                  
                  
                  
                  89Investment
      securities available-for-sale
                  
                  
                  240,175
                  
                  
                  
                  241,521Investment
      securities held-to-maturity (estimated fair value 2008 - $2,906; 2007 -
      $4,553)
                  
                  
                  2,990
                  
                  
                  
                  4,538Loans,
      net of unearned income
                  
                  
                  408,367
                  
                  
                  
                  376,603Allowance
      for loan losses
                  
                  
                  (5,195
                  )
                  
                  
                  (5,046
                  )Net
      loans
                  
                  $
                  403,172
                  
                  
                  $
                  371,557Premises
      and equipment, net
                  
                  
                  9,169
                  
                  
                  
                  8,486Accrued
      interest receivable
                  
                  
                  4,228
                  
                  
                  
                  3,241Cash
      surrender value of bank owned life insurance
                  
                  
                  17,157
                  
                  
                  
                  16,450Goodwill
                  
                  
                  19,133
                  
                  
                  
                  18,981Other
      assets
                  
                  
                  8,923
                  
                  
                  
                  6,458TOTAL
      ASSETS
                  
                  $
                  714,898
                  
                  
                  $
                  681,207LIABILITIESDeposits:Non-interest
      bearing
                  
                  $
                  58,178
                  
                  
                  $
                  58,844Interest
      bearing
                  
                  
                  446,455
                  
                  
                  
                  434,197Total
      Deposits
                  
                  
                  504,633
                  
                  
                  
                  493,041Short-term
      borrowings
                  
                  
                  55,332
                  
                  
                  
                  47,349Long-term
      borrowings
                  
                  
                  82,062
                  
                  
                  
                  66,175Accrued
      interest and other expenses
                  
                  
                  3,488
                  
                  
                  
                  3,454Other
      liabilities
                  
                  
                  236
                  
                  
                  
                  264TOTAL
      LIABILITIES
                  
                  $
                  645,751
                  
                  
                  $
                  610,283STOCKHOLDERS'
      EQUITYPreferred
      stock, par value $10.00 per share; authorized and unissued 500,000
      shares
                  
                  $
                  —
                  
                  
                  $
                  —Common
      stock, par value $2.00 per share; authorized 10,000,00 shares; issued
      5,687,767 in 2008 and 2007
                  
                  
                  11,375
                  
                  
                  
                  11,375Surplus
                  
                  
                  30,269
                  
                  
                  
                  30,252Retained
      earnings
                  
                  
                  38,414
                  
                  
                  
                  35,705Accumulated
      other comprehensive (loss)
                  
                  
                  (4,671
                  )
                  
                  
                  (166
                  )Treasury
      stock, at cost, 247,641 shares in 2008 and 247,691 shares in
      2007
                  
                  
                  (6,240
                  )
                  
                  
                  (6,242
                  )TOTAL
      STOCKHOLDERS' EQUITY
                  
                  $
                  69,147
                  
                  
                  $
                  70,924TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
                  
                  $
                  714,898
                  
                  
                  $
                  681,207
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
  31
  FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 CONSOLIDATED
STATEMENTS OF INCOME
 
 (Amounts
      in thousands, except per share data)
                    
                    Year Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006INTEREST
      INCOMEInterest
      and fees on loans
                    
                    $
                    25,408
                    
                    
                    $
                    19,049
                    
                    
                    $
                    16,484Interest
      and dividends on investment securities:Taxable
                    
                    
                    8,367
                    
                    
                    
                    9,484
                    
                    
                    
                    8,104Tax-exempt
                    
                    
                    3,514
                    
                    
                    
                    2,860
                    
                    
                    
                    3,574Dividends
                    
                    
                    256
                    
                    
                    
                    409
                    
                    
                    
                    384Deposits
      in banks
                    
                    
                    79
                    
                    
                    
                    66
                    
                    
                    
                    31Federal
      funds sold
                    
                    
                    14
                    
                    
                    
                    31
                    
                    
                    
                    —Total
      interest income
                    
                    $
                    37,638
                    
                    
                    $
                    31,899
                    
                    
                    $
                    28,577INTEREST
      EXPENSEDeposits
                    
                    $
                    13,908
                    
                    
                    $
                    13,557
                    
                    
                    $
                    11,184Short-term
      borrowings
                    
                    
                    669
                    
                    
                    
                    1,327
                    
                    
                    
                    893Long-term
      borrowings
                    
                    
                    3,539
                    
                    
                    
                    2,901
                    
                    
                    
                    2,895Total
      interest expense
                    
                    $
                    18,116
                    
                    
                    $
                    17,785
                    
                    
                    $
                    14,972Net
      interest income
                    
                    $
                    19,522
                    
                    
                    $
                    14,114
                    
                    
                    $
                    13,605Provision
      for loan losses
                    
                    
                    700
                    
                    
                    
                    150
                    
                    
                    
                    500Net
      interest income after provision for loan losses
                    
                    $
                    18,822
                    
                    
                    $
                    13,964
                    
                    
                    $
                    13,105NON-INTEREST
      INCOMETrust
      department
                    
                    $
                    530
                    
                    
                    $
                    581
                    
                    
                    $
                    507Service
      charges and fees
                    
                    
                    2,455
                    
                    
                    
                    2,183
                    
                    
                    
                    2,149Bank
      owned life insurance income
                    
                    
                    707
                    
                    
                    
                    558
                    
                    
                    
                    472Gain
      on sale of loans
                    
                    
                    136
                    
                    
                    
                    89
                    
                    
                    
                    39Investment
      securities gains (losses) - net
                    
                    
                    (148
                    )
                    
                    
                    483
                    
                    
                    
                    381Other
                    
                    
                    366
                    
                    
                    
                    305
                    
                    
                    
                    240Total
      non-interest income
                    
                    $
                    4,046
                    
                    
                    $
                    4,199
                    
                    
                    $
                    3,788NON-INTEREST
      EXPENSESalaries
      and employee benefits
                    
                    $
                    7,350
                    
                    
                    $
                    5,576
                    
                    
                    $
                    5,185Occupancy,
      net
                    
                    
                    1,064
                    
                    
                    
                    758
                    
                    
                    
                    608Furniture
      and equipment
                    
                    
                    936
                    
                    
                    
                    764
                    
                    
                    
                    751Professional
      services
                    
                    
                    516
                    
                    
                    
                    443
                    
                    
                    
                    402State
      shares tax
                    
                    
                    683
                    
                    
                    
                    572
                    
                    
                    
                    520Other
                    
                    
                    3,374
                    
                    
                    
                    2,532
                    
                    
                    
                    2,049Total
      non-interest expense
                    
                    $
                    13,923
                    
                    
                    $
                    10,645
                    
                    
                    $
                    9,515Income
      before income taxes
                    
                    $
                    8,945
                    
                    
                    $
                    7,518
                    
                    
                    $
                    7,378Income
      tax expense
                    
                    
                    1,394
                    
                    
                    
                    1,391
                    
                    
                    
                    1,188NET
      INCOME
                    
                    $
                    7,551
                    
                    
                    $
                    6,127
                    
                    
                    $
                    6,190PER
      SHARE DATANet
      income per share:*Basic
                    
                    $
                    1.39
                    
                    
                    $
                    1.31
                    
                    
                    $
                    1.35Diluted
                    
                    $
                    1.39
                    
                    
                    $
                    1.31
                    
                    
                    $
                    1.35Cash
      dividends per share*
                    
                    $
                    .89
                    
                    
                    $
                    .88
                    
                    
                    $
                    .85
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
  32
  FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
 
 (Amounts
      in thousands)
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      AccumulatedOtherCommon
                                      
                                      
                                      
                                      
                                      
                                      Comprehensive
                                      
                                      
                                      Retained
                                      
                                      
                                      Comprehensive
                                      
                                      
                                      TreasuryStock
                                      
                                      
                                      Surplus
                                      
                                      
                                      Income
                                      
                                      
                                      Earnings
                                      
                                      
                                      Income
      (Loss)
                                      
                                      
                                      Stock
                                      
                                      
                                      TotalBalance
      At December 31, 2005
                                      
                                      $
                                      9,079
                                      
                                      
                                      $
                                      12,387
                                      
                                      
                                      
                                      
                                      
                                      $
                                      35,714
                                      
                                      
                                      $
                                      807
                                      
                                      
                                      $
                                      (4,544
                                      )
                                      
                                      $
                                      53,443Comprehensive
      Income:Net
      income
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      $
                                      6,190
                                      
                                      
                                      
                                      6,190
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      6,190Change
      in net unrealized (loss) on investment securities available-for- sale, net
      of reclassification adjustment and tax effects
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (933
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      (933
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      (933
                                      )Total
      comprehensive income
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      $
                                      5,257Purchase
      of 79,691 shares of treasury stock
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (1,514
                                      )
                                      
                                      
                                      (1,514
                                      )Issuance
      of 4,415 shares of treasury stock upon exercise of employee stock
      options
                                      
                                      
                                      
                                      
                                      
                                      
                                      (77
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      148
                                      
                                      
                                      
                                      715%
      stock dividend
                                      
                                      
                                      432
                                      
                                      
                                      
                                      3,801
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (4,233
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      0Cash
      paid in lieu of fractional shares
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (4
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (4
                                      )Recognition
      of stock option expense
                                      
                                      
                                      
                                      
                                      
                                      
                                      8
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      8Cash
      dividends - $.85 per share
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (3,874
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (3,874
                                      )Balance
      At December 31, 2006
                                      
                                      $
                                      9,511
                                      
                                      
                                      $
                                      16,119
                                      
                                      
                                      
                                      
                                      
                                      
                                      $
                                      33,793
                                      
                                      
                                      $
                                      (126
                                      )
                                      
                                      $
                                      (5,910
                                      )
                                      
                                      $
                                      53,387Comprehensive
      Income:Net
      Income
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      $
                                      6,127
                                      
                                      
                                      
                                      6,127
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      6,127Change
      in net unrealized (loss) on investment securities available-for- sale, net
      of reclassification adjustment and tax effects
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (40
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      (40
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      (40
                                      )Total
      comprehensive income
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      $
                                      6,087Purchase
      of 18,791 shares oftreasury stock
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (332
                                      )
                                      
                                      
                                      (332
                                      )Issuance
      of 932,203 sharespursuant
      to acquisition
                                      
                                      
                                      1,864
                                      
                                      
                                      
                                      14,132
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      15,996Cumulative
      effect of change in accounting for deferred compensation endorsement
      split-dollar life insurance arrangements
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (36
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (36
                                      )Recognition
      of stock option expense
                                      
                                      
                                      
                                      
                                      
                                      
                                      1
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      1Cash
      dividends - $.88 per share
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (4,179
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      (4,179
                                      )Balance
      at December 31, 2007
                                      
                                      $
                                      11,375
                                      
                                      
                                      $
                                      30,252
                                      
                                      
                                      
                                      
                                      
                                      
                                      $
                                      35,705
                                      
                                      
                                      $
                                      (166
                                      )
                                      
                                      $
                                      (6,242
                                      )
                                      
                                      $
                                      70,924Comprehensive
      Income:Net
      Income
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      $
                                      7,551
                                      
                                      
                                      
                                      7,551
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      7,551Change
      in net unrealized (loss) on investment securities available-for- sale, net
      of reclassification adjustment and tax effects
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (4,505
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      (4,505
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      (4,505
                                      )Total
      comprehensive income
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      $
                                      3,046Issuance
      of 50 shares of treasury stock upon exercise of employee stock
      options
                                      
                                      
                                      
                                      
                                      
                                      
                                      (1
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      2
                                      
                                      
                                      
                                      1Recognition
      of stock option expense
                                      
                                      
                                      
                                      
                                      
                                      
                                      18
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      18Cash
      dividends - $.89 per share
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (4,842
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (4,842
                                      )Balance
      at December 31, 2008
                                      
                                      $
                                      11,375
                                      
                                      
                                      $
                                      30,269
                                      
                                      
                                      
                                      
                                      
                                      
                                      $
                                      38,414
                                      
                                      
                                      $
                                      (4,671
                                      )
                                      
                                      $
                                      (6,240
                                      )
                                      
                                      $
                                      69,147
  The accompanying notes are an integral
part of these consolidated financial statements.
  33
  FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 
 (Amounts
      in thousands)
                  
                  Year Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006OPERATING
      ACTIVITIESNet
      income
                  
                  $
                  7,551
                  
                  
                  $
                  6,127
                  
                  
                  $
                  6,190Adjustments
      to reconcile net income to net cash provided by operating
      activities:Provision
      for loan losses
                  
                  
                  700
                  
                  
                  
                  150
                  
                  
                  
                  500Depreciation
      and amortization
                  
                  
                  710
                  
                  
                  
                  663
                  
                  
                  
                  542Stock
      option expense
                  
                  
                  18
                  
                  
                  
                  1
                  
                  
                  
                  8Premium
      amortization on investment securities
                  
                  
                  95
                  
                  
                  
                  120
                  
                  
                  
                  187Discount
      accretion on investment securities
                  
                  
                  (677
                  )
                  
                  
                  (549
                  )
                  
                  
                  (537
                  )Impairment
      loss on investment securities
                  
                  
                  437
                  
                  
                  
                  —
                  
                  
                  
                  —Core
      deposit discount amortization net of accretion
                  
                  
                  181
                  
                  
                  
                  (35
                  )
                  
                  
                  1Deferred
      income tax benefit
                  
                  
                  (471
                  )
                  
                  
                  (104
                  )
                  
                  
                  (263
                  )Gain
      on sale of mortgage loans originated for resale
                  
                  
                  (136
                  )
                  
                  
                  (89
                  )
                  
                  
                  (39
                  )Proceeds
      from sale of mortgage loans originated for resale
                  
                  
                  8,992
                  
                  
                  
                  7,467
                  
                  
                  
                  7,470Originations
      of mortgage loans originated for resale
                  
                  
                  (12,218
                  )
                  
                  
                  (4,035
                  )
                  
                  
                  (9,013
                  )Gain
      on sales of investment securities
                  
                  
                  (289
                  )
                  
                  
                  (483
                  )
                  
                  
                  (381
                  )(Gain)
      Loss on sale of foreclosed real estate
                  
                  
                  (31
                  )
                  
                  
                  —
                  
                  
                  
                  13(Increase)
      decrease in accrued interest receivable
                  
                  
                  (987
                  )
                  
                  
                  41
                  
                  
                  
                  (38
                  )Increase
      in cash surrender value of bank owned life insurance
                  
                  
                  (707
                  )
                  
                  
                  (558
                  )
                  
                  
                  (472
                  )Increase
      in other assets - net
                  
                  
                  (104
                  )
                  
                  
                  (143
                  )
                  
                  
                  (82
                  )Increase
      in accrued interest and other expenses
                  
                  
                  32
                  
                  
                  
                  734
                  
                  
                  
                  208Decrease
      in other liabilities - net
                  
                  
                  85
                  
                  
                  
                  5
                  
                  
                  
                  (108
                  )Loss
      from sale of premises and equipment
                  
                  
                  —
                  
                  
                  
                  3
                  
                  
                  
                  —NET
      CASH PROVIDED BY OPERATING ACTIVITIES
                  
                  $
                  3,181
                  
                  
                  $
                  9,315
                  
                  
                  $
                  4,186INVESTING
      ACTIVITIESProceeds
      from sales of investment securities available-for-sale
                  
                  $
                  83,626
                  
                  
                  $
                  83,255
                  
                  
                  $
                  103,736Proceeds
      from maturities and redemptions of investment securities
      available-for-sale
                  
                  
                  36,148
                  
                  
                  
                  22,874
                  
                  
                  
                  28,583Purchases
      of investment securities available-for-sale
                  
                  
                  (124,847
                  )
                  
                  
                  (96,788
                  )
                  
                  
                  (122,716
                  )Proceeds
      from maturities and redemption of investment securities
      held-to-maturity
                  
                  
                  2,015
                  
                  
                  
                  2,012
                  
                  
                  
                  110Proceeds
      from sales of investment securities held-to-maturity
                  
                  
                  —
                  
                  
                  
                  375
                  
                  
                  
                  201Purchases
      of investment securities held-to-maturity
                  
                  
                  (467
                  )
                  
                  
                  —
                  
                  
                  
                  (3,015
                  )Net
      increase in loans
                  
                  
                  (29,184
                  )
                  
                  
                  (22,277
                  )
                  
                  
                  (16,087
                  )Purchases
      of premises and equipment
                  
                  
                  (1,476
                  )
                  
                  
                  (692
                  )
                  
                  
                  (218
                  )Purchase
      of investment in real estate venture
                  
                  
                  (18
                  )
                  
                  
                  (485
                  )
                  
                  
                  —Purchase
      of bank net of cash acquired
                  
                  
                  —
                  
                  
                  
                  (13,626
                  )
                  
                  
                  —Proceeds
      from sales of premises and equipment
                  
                  
                  —
                  
                  
                  
                  2
                  
                  
                  
                  —Purchase
      of bank owned life insurance
                  
                  
                  —
                  
                  
                  
                  (1,000
                  )
                  
                  
                  —Proceeds
      from sale of foreclosed real estate
                  
                  
                  384
                  
                  
                  
                  41
                  
                  
                  
                  320Decrease
      in other liabilities related to acquisition
                  
                  
                  (152
                  )
                  
                  
                  —
                  
                  
                  
                  —NET
      CASH (USED IN) INVESTING ACTIVITIES
                  
                  $
                  (33,971
                  )
                  
                  $
                  (26,309
                  )
                  
                  $
                  (9,086
                  )FINANCING
      ACTIVITIESNet
      increase (decrease) in deposits
                  
                  $
                  11,701
                  
                  
                  $
                  (616
                  )
                  
                  $
                  21,225Net
      increase in short-term borrowings
                  
                  
                  7,983
                  
                  
                  
                  17,170
                  
                  
                  
                  28Proceeds
      from long-term borrowings
                  
                  
                  25,000
                  
                  
                  
                  15,000
                  
                  
                  
                  5,000Repayment
      of long-term borrowings
                  
                  
                  (9,077
                  )
                  
                  
                  (10,262
                  )
                  
                  
                  (13,000
                  )Cash
      paid in lieu of fractional shares
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  (4
                  )Proceeds
      from sale of treasury stock
                  
                  
                  1
                  
                  
                  
                  —
                  
                  
                  
                  71Acquisition
      of treasury stock
                  
                  
                  —
                  
                  
                  
                  (332
                  )
                  
                  
                  (1,514
                  )Cash
      dividends paid
                  
                  
                  (4,842
                  )
                  
                  
                  (4,179
                  )
                  
                  
                  (3,874
                  )NET
      CASH PROVIDED BY FINANCING ACTIVITIES
                  
                  $
                  30,766
                  
                  
                  $
                  16,781
                  
                  
                  $
                  7,932INCREASE
      (DECREASE) IN CASH AND CASH EQUIVALENTS
                  
                  $
                  (24
                  )
                  
                  $
                  (213
                  )
                  
                  $
                  3,032CASH
      AND CASH EQUIVALENTS AT BEGINNING OF YEAR
                  
                  
                  9,975
                  
                  
                  
                  10,188
                  
                  
                  
                  7,156CASH
      AND CASH EQUIVALENTS AT END OF YEAR
                  
                  $
                  9,951
                  
                  
                  $
                  9,975
                  
                  
                  $
                  10,188
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
  34
  FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006
  NOTE
1  —  SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES
 
 The
accounting policies of First Keystone Corporation and Subsidiary (the
“Corporation”) are in accordance with accounting principles generally accepted
in the United States of America and conform to common practices within the
banking industry. The more significant policies follow:
 
 Principles
of Consolidation
 
 The
consolidated financial statements include the accounts of First Keystone
Corporation and its wholly-owned Subsidiary, First Keystone National Bank (the
“Bank”). All significant inter-company balances and transactions have been
eliminated in consolidation.
 
 Nature
of Operations
 
 The
Corporation, headquartered in Berwick, Pennsylvania, provides a full range of
banking, trust and related services through its wholly-owned Bank subsidiary and
is subject to competition from other financial institutions in connection with
these services. The Bank serves a customer base which includes individuals,
businesses, public and institutional customers primarily located in the
Northeast Region of Pennsylvania. The Bank has 14 full service offices and 16
ATMs located in Columbia, Luzerne, Montour and Monroe Counties. The Corporation
and its subsidiary must also adhere to certain federal banking laws and
regulations and are subject to periodic examinations made by various federal
agencies.
 
 Segment
Reporting
 
 The
Corporation's banking subsidiary acts as an independent community financial
services provider, and offers traditional banking and related financial services
to individual, business and government customers. Through its branch and
automated teller machine network, the Bank offers a full array of commercial and
retail financial services, including the taking of time, savings and demand
deposits; the making of commercial, consumer and mortgage loans; and the
providing of other financial services. The Bank also performs personal,
corporate, pension and fiduciary services through its Trust
Department.
 
 Management
does not separately allocate expenses, including the cost of funding loan
demand, between the commercial, retail, trust and mortgage banking operations of
the Corporation. Currently, management measures the performance and allocates
the resources of First Keystone Corporation as a single segment.
 
 Use
of Estimates
 
 The
preparation of these consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America,
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of these consolidated financial statements and the
reported amounts of income and expenses during the reporting periods. Actual
results could differ from those estimates.
 
 Investment
Securities
 
 The
Corporation classifies its investment securities as either “Held-to-Maturity” or
“Available-for-Sale” at the time of purchase. Debt securities are classified as
Held-to-Maturity when the Corporation has the ability and positive intent to
hold the securities to maturity. Investment securities Held-to-Maturity are
carried at cost adjusted for amortization of premium and accretion of discount
to maturity.
 
 Debt
securities not classified as Held-to-Maturity and equity securities are included
in the Available-for-Sale category and are carried at fair value. The amount of
any unrealized gain or loss, net of the effect of deferred income taxes, is
reported as other comprehensive income (loss) in the Consolidated Statement of
Changes in Stockholders’ Equity. Management's decision to sell
Available-for-Sale securities is based on changes in economic conditions
controlling the sources and applications of funds, terms, availability of and
yield of alternative investments, interest rate risk and the need for
liquidity.
  35
  FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006
 
 The cost
of debt securities classified as Held-to-Maturity or Available-for-Sale is
adjusted for amortization of premiums and accretion of discounts to expected
maturity. Such amortization and accretion, as well as interest and dividends is
included in interest income from investments. Realized gains and losses are
included in net investment securities gains and losses.
 
 The cost
of investment securities sold, redeemed or matured is based on the specific
identification method.
 
 Loans
 
 Loans are
stated at their outstanding unpaid principal balances, net of deferred fees or
costs, unearned income and the allowance for loan losses. Interest on
installment loans is recognized as income over the term of each loan, generally,
by the actuarial method. Interest on all other loans is primarily recognized
based upon the principal amount outstanding on an actual day basis. Loan
origination fees and certain direct loan origination costs have been deferred
with the net amount amortized using the interest method over the contractual
life of the related loans as an interest yield adjustment.
 
 Mortgage
loans held for resale are carried at the lower of cost or market on an aggregate
basis. These loans are sold without recourse to the Corporation.
 
 Past-Due Loans —Generally, a
loan is considered to be past-due when scheduled loan payments are in arrears 15
days or more. Delinquent notices are generated automatically when a loan is 15
days past-due, depending on the type of loan. Collection efforts continue on
loans past-due beyond 60 days that have not been satisfied, when it is believed
that some chance exists for improvement in the status of the loan. Past-due
loans are continually evaluated with the determination for charge-off being made
when no reasonable chance remains that the status of the loan can be
improved.
 
 Non-Accrual Loans —Generally, a loan is classified as non-accrual and the accrual of
interest on such a loan is discontinued when the contractual payment of
principal or interest has become 90 days past due or management has serious
doubts about further collectibility of principal or interest, even though the
loan currently is performing. A loan may remain on accrual status if it is in
the process of collection and is either guaranteed or well secured. When a loan
is placed on non-accrual status, unpaid interest credited to income in the
current year is reversed and unpaid interest accrued in prior years is charged
against the allowance for loan losses. Certain non-accrual loans may continue to
perform, that is, payments are still being received. Generally, the payments are
applied to principal. These loans remain under constant scrutiny and if
performance continues, interest income may be recorded on a cash basis based on
management's judgement as to collectibility of principal.
 
 Allowance for Loan Losses —
The allowance for loan losses is established through provisions for loan losses
charged against income. Loans deemed to be uncollectible are charged against the
allowance for loan losses and subsequent recoveries, if any, are credited to the
allowance.
 
 A
principal factor in estimating the allowance for loan losses is the measurement
of impaired loans. A loan is considered impaired when, based on current
information and events, it is probable that the Corporation will be unable to
collect all amounts due according to the contractual terms of the loan
agreement. Under current accounting standards, the allowance for loan losses
related to impaired loans is based on discounted cash flows using the effective
interest rate of the loan or the fair value of the collateral for certain
collateral dependent loans.
 
 The
allowance for loan losses is maintained at a level estimated by management to be
adequate to absorb potential loan losses. Management's periodic evaluation of
the adequacy of the allowance for loan losses is based on the Corporation's past
loan loss experience, known and inherent risks in the portfolio, adverse
situations that may affect the borrower's ability to repay (including the timing
of future payments), the estimated value of any underlying collateral,
composition of the loan portfolio, current economic conditions, and other
relevant factors. This evaluation is inherently subjective as it requires
material estimates including the amounts and timing of future cash flows
expected to be received on impaired loans that may be susceptible to significant
change.
  36
  FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 - Continued
 
 Premises
and Equipment
 
 Premises,
improvements and equipment are stated at cost less accumulated depreciation
computed principally on the straight-line method over the estimated useful lives
of the assets. Long-lived assets are reviewed for impairment whenever events or
changes in business circumstances indicate that the carrying value may not be
recovered.  Maintenance and minor repairs are charged to operations as
incurred. The cost and accumulated depreciation of the premises and equipment
retired or sold are eliminated from the property accounts at the time of
retirement or sale, and the resulting gain or loss is reflected in current
operations.
 
 Mortgage
Servicing Rights
 
 The
Corporation originates and sells real estate loans to investors in the secondary
mortgage market. After the sale, the Corporation may retain the right to service
these loans. When originated mortgage loans are sold and servicing is retained,
a servicing asset is capitalized based on relative fair value at the date of
sale. Servicing assets are amortized as an offset to other fees in proportion
to, and over the period of, estimated net servicing income. The unamortized cost
is included in other assets in the accompanying consolidated balance sheet. The
servicing rights are periodically evaluated for impairment based on their
relative fair value.
 
 Foreclosed
Real Estate
 
 Real
estate properties acquired through, or in lieu of, loan foreclosure are held for
sale and are initially recorded at fair value on the date of foreclosure
establishing a new cost basis. After foreclosure, valuations are periodically
performed by management and the real estate is carried at the lower of carrying
amount or fair value less cost to sell and is included in other assets. Revenues
derived from and costs to maintain the assets and subsequent gains and losses on
sales are included in other non-interest income and expense.  The
total of foreclosed real estate properties included in other assets amounted to
$28,000 and $65,000 at December 31, 2008 and 2007, respectively.
 
 Bank
Owned Life Insurance
 
 The
Corporation invests in Bank Owned Life Insurance (BOLI) with split dollar life
provisions.  Purchase of BOLI provides life insurance coverage on
certain employees with the Corporation being owner and beneficiary of the
policies.
 
 Investments
in Real Estate Ventures
 
 The Bank
is a limited partner in  real estate ventures that own and operate
affordable residential low-income housing apartment buildings for elderly
residents. The investments are accounted for under the effective yield method
under the Emerging Issues Task Force (EITF) 94-1, “Accounting for Tax Benefits
Resulting from Investments in Affordable Housing Projects”. Under the effective
yield method, the Bank recognizes tax credits as they are allocated and
amortizes the initial cost of the investment to provide a constant effective
yield over the period that the tax credits are allocated to the
Bank.  Under this method, the tax credits allocated, net of any
amortization of the investment in the limited partnerships, are recognized in
the consolidated statements of income as a component of income tax
expense.  The amount of tax credits allocated to the Bank were
$187,000 in 2008, $151,000 in 2007 and $128,000 in 2006, and the amortization of
the investments in the limited partnerships were $148,000, $108,000 and $100,000
in 2008, 2007 and 2006, respectively.  The carrying value of the
investments as of December 31, 2008, 2007 and 2006, was $844,000, $975,000 and
$595,000, respectively, and is included in other assets in the accompanying
consolidated balance sheets.
 
 Income
Taxes
 
 The
provision for income taxes is based on the results of operations, adjusted
primarily for tax-exempt income. Certain items of income and expense are
reported in different periods for financial reporting and tax return purposes.
Deferred tax assets and liabilities are determined based on the differences
between the consolidated financial statement and income tax bases of assets and
liabilities measured by using the enacted tax rates and laws expected to be in
effect when the timing differences are expected to reverse. Deferred tax expense
or benefit is based on the difference between deferred tax asset or liability
from period to period.
  37
  FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 - Continued
 
 Goodwill,
Other Intangible Assets, and Premium Discount
 
 Goodwill
resulted from the acquisition of the Pocono Community Bank in November 2007 (See
Note 2) and of certain fixed and operating assets acquired and deposit
liabilities assumed of the branch of another financial institution in Danville,
Pennsylvania, in January 2004.  Such goodwill represents the excess
cost of the acquired assets relative to the assets fair value at the dates of
acquisition.  The Corporation accounts for goodwill pursuant to the
Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and
Intangible Assets”.  During the first quarter of 2008, $152,000 of
liabilities were recorded related to the Pocono acquisition as a purchase
accounting adjustment resulting in an increase in the excess purchase price. The
amount was comprised of the finalization of severance agreements and contract
terminations related to the acquisition. SFAS No. 142 includes requirements to
test goodwill for impairments rather than to amortize goodwill.  The
Corporation has tested the goodwill included in its consolidated balance sheet
at December 31, 2008, and has determined there was no impairment as of that
date.
 
 Intangible
assets are comprised of core deposit intangibles and premium discount (negative
premium) on certificates of deposit acquired.  The core deposit
intangible is being amortized over the average life of the deposits acquired as
determined by an independent third party.  Premium discount (negative
premium) on acquired certificates of deposit resulted from the valuation of
certificate of deposit accounts by an independent third party.  The
book value of certificates of deposit acquired was greater than their fair value
at the date of acquisition which resulted in a negative premium due to higher
cost of the certificates of deposit compared to the cost of similar term
financing.
 
 Stock
Based Compensation
 
 The
Corporation sponsors a stock option plan (see Note 21).  Prior to
January 1, 2006 the Corporation had accounted for this Plan under the fair value
recognition and measurement provisions of Statement of Financial Accounting
Standards (SFAS) 123, “Accounting for Stock Based
Compensation”.  Effective January 1, 2006 the Corporation adopted SFAS
123 (revised 2004), “Share-Based Payment”, using the modified prospective
application method.  Based on the terms of the Plan, the Corporation
did not have a cumulative effect related to the Plan.  Since the fair
value recognition provisions of SFAS 123 and SFAS 123R are essentially the same
as they relate to the Corporation’s Plan, the adoption of SFAS 123R did not and
will not have a material impact on the Corporation’s consolidated financial
condition, results of operations or liquidity.  The fair values of the
stock awards are determined using the estimated expected life.  The
Corporation recognizes stock based compensation expense on the straight line
basis over the period the stock award is earned by the employee.
 
 Per
Share Data
 
 Statement
of Financial Accounting Standards (SFAS) No. 128, “Earnings Per Share”, requires
dual presentation of basic and fully diluted earnings per share. Basic earnings
per share is calculated by dividing net income by the weighted average number of
shares of common stock outstanding at the end of each period. Diluted earnings
per share is calculated by increasing the denominator for the assumed conversion
of all potentially dilutive securities. The Corporation's dilutive securities
are limited to stock options.  The most recent options issued were in
December 2007.
 
 Per share
data has been adjusted retroactively for stock splits and stock
dividends.  The reconciliation of the numerators and denominators of
the basis and diluted earnings per share follows:
  38
 
 FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 - Continued
  Year Ended December 31,
2008Weighted
      AverageNet
      Income
                                  
                                  
                                  Number
      of Shares
                                  
                                  
                                  Per
      ShareNumerators
                                  
                                  
                                  Denominators
                                  
                                  
                                  AmountNet
      income
                                  
                                  $
                                  7,551Basic
      earnings per share:Income
      available to common stockholders
                                  
                                  $
                                  7,551
                                  
                                  
                                  
                                  5,440
                                  
                                  
                                  $
                                  1.39Effect
      of dilutive securities:Stock
      options
                                  
                                  
                                  
                                  
                                  
                                  
                                  2Diluted
      earnings per share:Income
      available to common stockholders
                                  
                                  $
                                  7,551
                                  
                                  
                                  
                                  5,442
                                  
                                  
                                  $
                                  1.39Year Ended December 31,
2007Weighted
      AverageNet
      Income
                                  
                                  
                                  Number
      of Shares
                                  
                                  
                                  Per
      ShareNumerators
                                  
                                  
                                  Denominators
                                  
                                  
                                  AmountNet
      income
                                  
                                  $
                                  6,127Basic
      earnings per share:Income
      available to common stockholders
                                  
                                  $
                                  6,127
                                  
                                  
                                  
                                  4,674
                                  
                                  
                                  $
                                  1.31Effect
      of dilutive securities:Stock
      options
                                  
                                  
                                  
                                  
                                  
                                  
                                  6Diluted
      earnings per share:Income
      available to common stockholders
                                  
                                  $
                                  6,127
                                  
                                  
                                  
                                  4,680
                                  
                                  
                                  $
                                  1.31Year Ended December 31,
2006Weighted
      AverageNet
      Income
                                  
                                  
                                  Number
      of Shares
                                  
                                  
                                  Per
      ShareNumerators
                                  
                                  
                                  Denominators
                                  
                                  
                                  AmountNet
      income
                                  
                                  $
                                  6,190Basic
      earnings per share:Income
      available to common stockholders
                                  
                                  $
                                  6,190
                                  
                                  
                                  
                                  4,571
                                  
                                  
                                  $
                                  1.35Effect
      of dilutive securities:Stock
      options
                                  
                                  
                                  
                                  
                                  
                                  
                                  7Diluted earnings per share:Income
      available to common stockholders
                                  
                                  $
                                  6,190
                                  
                                  
                                  
                                  4,578
                                  
                                  
                                  $
                                  1.35
  Cash
Flow Information
 
 For
purposes of reporting consolidated cash flows, cash and cash equivalents include
cash on hand and due from other banks and interest bearing deposits in other
banks. The Corporation considers cash classified as interest bearing deposits
with other banks as a cash equivalent since they are represented by cash
accounts essentially on a demand basis.
  39




FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 - Continued








Trust
Assets and Income





Property
held by the Corporation in a fiduciary or agency capacity for its customers is
not included in the accompanying consolidated financial statements since such
items are not assets of the Corporation. Trust Department income is
generally  recognized on a cash basis and is not materially different
than if it were reported on an accrual basis.





Recent
Accounting Pronouncements





In
December 2008, the FASB issued FASB Staff Position No. SFAS 140-4 and FIN
46(R)-8 (FSP 140-4), “Disclosures by Public Entities
(Enterprises) about Transfers of Financial Assets and Interests in Variable
Interest Entities”.  FSP 140-4 amends FASB Statement No. 140 to
require public entities to provide additional disclosures about transfers of
financial assets. It also amends FASB Interpretation No. 46 to require public
enterprises, including sponsors that have a variable interest in a variable
interest entity, to provide additional disclosures about their involvement with
variable interest entities.





Additionally,
this FSP requires certain disclosures to be provided by a public enterprise that
is (a) a sponsor of a qualifying special purpose entity (“QSPE”) that holds a
variable interest in the QSPE but was not the transferor (non-transferor) of
financial assets to the QSPE; and (b) a servicer of a QSPE that holds a
significant interest in the QSPE but was not the transferor (non-transferor) of
financial assets to the QSPE. The Corporation does not have involvement with any
variable interest entities.





In
January 2009, the FASB ratified EITF 99-20-1, “Amendments to the Impairment
Guidance of EITF Issue 99-20”. EITF 99-20-1 amends the impairment
guidance in EITF 99-20 to achieve more consistent determination of whether an
other-than-temporary impairment has occurred. EITF 99-20-1 was effective
December 31, 2008. The change in the impairment guidance with the issuance of
FSP EITF 99-20-1did not result in any material impact on the Corporation’s
consolidated financial condition, results if operation or
liquidity.





In
December 2007, the Financial Accounting Standards Board (FASB) issued State of
Financial Accounting Standards SFAS 141(R), “Business Combinations”. SFAS
141(R) will significantly change how entities apply the acquisition method to
business combinations. The most significant changes affecting how the
Corporation will account for business combinations under this Statement include:
the acquisition date will be the date the acquirer obtains control; all (and
only) identifiable assets acquired, liabilities assumed, and noncontrolling
interests in the acquiree will be stated at fair value on the acquisition date;
assets or liabilities arising from noncontractual contingencies will be measured
at their acquisition date fair value only if it is more likely than not that
they meet the definition of an asset or liability on the acquisition date;
adjustments subsequently made to the provisional amounts recorded on the
acquisition date will be made retroactively during a measurement period not to
exceed one year; acquisition-related restructuring costs that do not meet the
criteria in SFAS 146, “Accounting for Costs Associated
with Exit or Disposal Activities”, will be expensed as incurred;
transaction costs will be expensed as incurred; reversals of deferred income tax
valuation allowances and income tax contingencies will be recognized in earnings
subsequent to the measurement period; and the allowance for loan losses of an
acquiree will not be permitted to be recognized by the acquirer. Additionally,
SFAS 141(R) will require new and modified disclosures surrounding subsequent
changes to acquisition-related contingencies, contingent consideration,
noncontrolling interests, acquisition-related transaction costs, fair values and
cash flows not expected to be collected for acquired loans, and an enhanced
goodwill rollforward.





The
Corporation will be required to prospectively apply SFAS 141(R) to all business
combinations completed on or after January 1, 2009. Early adoption is not
permitted. For business combinations in which the acquisition date was before
the effective date, the provisions of SFAS 141(R) will apply to the subsequent
accounting for deferred income tax valuation allowances and income tax
contingencies and will require any changes in those amounts to be recorded in
earnings. The Corporation will adopt SFAS 141(R) for any business combinations
occurring at or subsequent to January 1, 2009.


40


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued








In
December 2007, the FASB issued Statement of Financial Accounting Standards SFAS
160, “Noncontrolling Interests
in Consolidated Financial Statements, an Amendment of ARB 51". SFAS 160
establishes new accounting and reporting standards for noncontrolling interests
in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 will
require entities to classify noncontrolling interests as a component of
stockholders’ equity and will require subsequent changes in ownership interest
in a subsidiary to be accounted for as an equity transaction. Additionally, SFAS
160 will require entities to recognize a gain or loss upon the loss of control
of a subsidiary and to remeasure any ownership interest retained at fair value
on that date. This statement also requires expanded disclosures that clearly
identify and distinguish between the interests of the parent and the interests
of the noncontrolling owners. SFAS 160 is effective on a prospective basis for
fiscal years, and interim periods within those fiscal years, beginning on or
after December 15, 2008, except for the presentation and disclosure
requirements, which are required to be applied retrospectively. Early adoption
is not permitted. The adoption of this standard is not expected to have a
material impact on the Corporation’s consolidated financial condition, results
of operations or liquidity.





EITF
06-4, “Accounting for Deferred
Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life
Insurance Arrangements”, was issued in September 2006 and is effective
for fiscal years beginning after December 15, 2007 with earlier application
permitted. EITF 06-4 requires that, for split-dollar life insurance arrangements
that provide a benefit to an employee that extends to postretirement periods, an
employer should recognize a liability for future benefits in accordance with
SFAS No. 106. EITF 06-4 requires that recognition of the effects of adoption
should be either by (a) a change in accounting principle through a
cumulative-effect adjustment to retained earnings as of the beginning of the
year of adoption or (b) a change in accounting principle through retrospective
application to all prior periods. The Corporation adopted this standard as of
January 1, 2007 through a cumulative-effect adjustment to beginning retained
earnings. This adjustment represented a decrease of $36,000 to retained
earnings.





In June
2007, the FASB ratified the consensus reached in EITF 06-11, “Accounting for Income Tax Benefits
of Dividends on Share-Based Payment Awards”. EITF 06-11 applies to
entities that have share-based payment arrangements that entitle employees to
receive dividends or dividend equivalents on equity-classified nonvested shares
when those dividends or dividend equivalents are charged to retained earnings
and result in an income tax deduction. Entities that have share-based payment
arrangements that fall within the scope of EITF 06-11 will be required to
increase capital surplus for any realized income tax benefit associated with
dividends or dividend equivalents paid to employees for equity classified
nonvested equity awards. Any increase recorded to capital surplus is required to
be included in any entity’s pool of excess tax benefits that are available to
absorb potential future tax deficiencies on share-based payment awards. The
Corporation adopted ITF 06-11 on January 1, 2008 for dividends declared on
share-based payment awards subsequent to this date. The impact of adoption did
not have any material impact on the Corporation’s consolidated financial
condition, results of operations, or liquidity.





In April
2007, the FASB issued FSP 39-1, “Amendments of FASB Interpretation
No. 39. Offsetting of Amounts Related to Certain Contracts”. FSP 39-1
permits entities to offset fair value amounts recognized for multiple derivative
instruments executed with the same counterparty under a master netting
agreement. FSP 39-1 clarifies that the fair value amounts recognized for the
right to reclaim cash collateral, or the obligation to return cash collateral,
arising from the same master netting arrangement, should also be offset against
the fair value of the related derivative instruments.





Effective
January 1, 2008, the Corporation adopted a net presentation for derivative
positions and related collateral entered into under master netting agreements
pursuant to the guidance in FIN 39 and FSP 39-1. The adoption of this guidance
would result in balance sheet reclassifications of certain cash collateral-based
short-term investments against the related derivative liabilities and certain
deposit liability balances against the related fair values of derivative assets.
The effects of these reclassifications will fluctuate based on the fair values
of derivative contracts but overall would not have a material impact on either
total assets or total liabilities. The adoption of these standards did not have
an impact on the Corporation’s consolidated financial condition, results of
operations or liquidity.





In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial
Assets and Liabilities”. The statement allows an entity to elect to
measure certain financial assets and liabilities at fair value with changes in
fair value recognized in the income statement each period. The statement also
requires additional disclosures to identify the effects of an entity’s fair
value election on its earnings. The election is irrevocable. The Corporation has
chosen not to elect to measure any specific group of financial assets or
liabilities pursuant to SFAS 159.


41


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 - Continued








In
September 2006, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards SFAS 158 “Employers’ Accounting for Defined
Benefit Pension and Other Post Retirement Plans”, which requires the
Corporation to recognize the funded status of a benefit plan as either assets or
liabilities in the consolidated balance sheet and to recognize as a component of
other comprehensive income, net of tax, unrecognized actuarial gains or losses,
prior service costs and transition obligations that arise during the period. The
adoption of SFAS 158 for year ended December 31, 2007 did not have a material
impact on the Corporation’s consolidated financial position, results of
operations, or liquidity.





In
September 2006, the FASB issued Statement of Financial Accounting Standards
(SFAS) 157, “Fair Value
Measurements”, which upon adoption will replace various definitions of
fair value in existing accounting literature with a single definition, will
establish a framework for measuring fair value, and will require additional
disclosures about fair value measurements. The statement clarifies that fair
value is the price that would be received to sell an asset or the price paid to
transfer a liability in the most advantageous market available to the entity and
emphasizes that fair value is a market-based measurement and should be based on
the assumptions market participants would use. The statement also creates a
three-level hierarchy under which individual fair value estimates are to be
ranked based on the relative reliability of the inputs used in the valuation.
This hierarchy is the basis for the disclosure requirements, with fair value
estimates based on the least reliable inputs requiring more extensive
disclosures about the valuation method used and the gains and losses associated
with those estimates. SFAS 157 is required to be applied whenever another
financial accounting standard requires or permits an asset or liability to be
measured at fair value. The statement does not expand the use of fair value to
any new circumstances. The Corporation has applied the new guidance beginning
January 1, 2008, and such application did not have a material impact on the
Corporation’s consolidated financial condition, results of operations, or
liquidity.





In July
2006, the FASB issued FASB Staff Position FSP 13-2, “Accounting for a Change or
Projected Change in the Timing of Cash Flows Related to Income Taxes Generated
by a Leveraged Lease Transaction”. This FSP amends SFAS 13, “Accounting for Leases”, to
require a lessor in a leveraged lease transaction to recalculate the leveraged
lease for the effects of a change or projected change in the timing of cash
flows relating to income taxes that are generated by the leveraged lease. The
guidance in FSP 13-2 was adopted by the Corporation on January 1, 2007. The
application of this FSP did not have a material impact on the Corporation’s
consolidated financial condition, results of operations, or
liquidity.





In June
2006, the FASB issued Interpretation No. 48 FIN 48, “Accounting for Uncertainty in
Income Taxes”, an interpretation of SFAS 109, “Accounting for Income
Taxes”. FIN 48 prescribes a comprehensive model for how companies should
recognize, measure, present, and disclose in their financial statements
uncertain tax positions taken or expected to be taken on a tax return. Under FIN
48, tax positions shall initially be recognized in the financial statements when
it is more likely than not the position will be sustained upon examination by
the tax authorities. Such tax positions shall initially and subsequently be
measured as the largest amount of tax benefit that is greater than 50% likely of
being realized upon ultimate settlement with the tax authority assuming full
knowledge of the position and all relevant facts. FIN 48 also revises disclosure
requirements to include an annual tabular roll-forward of unrecognized tax
benefits. The provisions of this interpretation were adopted by the Corporation
on January
1, 2007. The adoption of FIN 48 did not have a material impact on the
Corporation’s consolidated financial condition, result of operations, or
liquidity.





In March
2006, the FASB issued Statement of Financial Accounting Standards SFAS 156,
“Accounting for Servicing of
Financial Assets”, an amendment of SFAS 140. This standard requires
entities to separately recognize a servicing asset or liability whenever it
undertakes an obligation to service financial assets and also requires all
separately recognized servicing assets or liabilities to be initially measured
at fair value. Additionally, this standard permits entities to choose among two
alternatives, the amortization method or fair value measurement method, for the
subsequent measurement of each class of separately recognized servicing assets
and liabilities. Under the amortization method, an entity shall amortize the
value of servicing assets or liabilities in proportion to and over the period of
estimated net servicing income or net servicing loss and assess servicing assets
or liabilities for impairment or increased obligation based on fair value at
each reporting date. Under the fair value measurement method, an entity shall
measure servicing assets or liabilities at fair value at each reporting date and
report changes in fair value in earnings in the period in which the changes
occur.


42


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 - Continued








Effective
January 1, 2006, the Corporation adopted this statement by electing amortization
method as the measurement method for residential real estate mortgage servicing
rights (MSRs).





In
February 2006, the FASB issued Statement of Financial Accounting Standards SFAS
155, “Accounting for Certain
Hybrid Financial Instruments”, which amends SFAS 133, “Accounting for Derivative
Instruments and Hedging Activities”, and SFAS 140, “Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities”. SFAS
155 requires entities to evaluate and identify whether interests in securitized
financial assets are freestanding derivatives, hybrid financial instruments that
contain an embedded derivative requiring bifurcation, or hybrid financial
instruments that contain embedded derivatives that do not require bifurcation.
SFAS 155 also permits fair value measurement for any hybrid financial instrument
that contains an embedded derivative that otherwise would require bifurcation.
This statement was effective for all financial instruments acquired or issued by
the Corporation on or after January 1, 2007 and the adoption of SFAS 155 did not
have a material impact on the Corporation’s consolidated financial condition,
results of operations or liquidity.





Advertising
Costs





It is the
Corporation’s policy to expense advertising costs in the period in which they
are incurred. Advertising expense for the years ended December 31, 2008, 2007
and 2006, was approximately $316,000, $349,000 and $248,000,
respectively.





Reclassifications





Certain
amounts in the consolidated financial statements of prior periods have been
reclassified to conform with presentation used in the 2008 consolidated
financial statements. Such reclassifications have no effect on the Corporation’s
consolidated financial condition or net income.





NOTE
2  —   ACQUISITIONS





Effective
November 1, 2007, the Corporation completed its acquisition of Pocono Community
Bank. Under the terms of the Agreement and Plan of Merger dated as of May 10,
2007, Pocono was acquired by First Keystone Corporation and merged with and into
First Keystone National Bank, its wholly owned subsidiary. Headquartered and
founded in Stroudsburg, Pennsylvania in 1996, Pocono had 4 banking offices
located in Monroe County, Pennsylvania.  The acquisition expands the
branch network that the Corporation has and its opportunity to provide Pocono
customers with a broader mix of products and services. As part of the merger
agreement, Pocono continues to operate under the Pocono name and logo, and has
become a division of the Bank. The Corporation acquired 100% of the outstanding
shares of Pocono for a total purchase price of $33.565 million. The transaction
was accounted for in accordance with SFAS No. 141, “Business Combinations.” In
connection therewith, 1,042,266 Pocono shares were exchanged for 932,203 shares
of the Corporation’s common stock and 703,684 Pocono shares were exchanged for
cash consideration totaling $11.329 million. Pocono options of 63,785 and
warrants of 396,134 were exchanged for cash consideration of $5.034 million. The
allocation of the Corporation’s common stock and cash was such that the Pocono
shareholders did not recognize gain or loss for federal income tax purposes on
those Pocono shares that were exchanged for the Corporation’s common stock in
the merger. Pocono’s results of operations are included in the Corporation’s
results from the date of acquisition, November
1, 2007 to December 31, 2007.





Assets
and liabilities of Pocono are recorded at estimated fair values as of the
acquisition date and the results of Pocono’s operations included in income from
November 1, 2007 to December 31, 2007. The fair values of acquired assets and
liabilities, including identifiable intangible assets, are finalized as quickly
as possible following an acquisition. The purchase price allocations are
complete.




43




FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 - Continued








The
following table shows the excess purchase price over carrying value of net
assets acquired, purchase price allocation and resulting goodwill recorded for
this acquisition:





(Amounts
      in thousands)Purchase
      price
                    
                    $
                    33,565Carrying
      value of net assets acquired
                    
                    
                    (14,329
                    )Excess
      of purchase price over carrying value of net assets
    acquired
                    
                    
                    19,236Purchase
      accounting adjustments:Investment
      securities
                    
                    
                    182Loans
                    
                    
                    1,101Premises
      and equipment
                    
                    
                    (148
                    )Deposits
                    
                    
                    167Borrowings
                    
                    
                    97Severance
      and related costs
                    
                    
                    (877
                    )Deferred
      taxes
                    
                    
                    232Subtotal
                    
                    
                    19,990Core
      deposit intangibles
                    
                    
                    (2,081
                    )Goodwill
                    
                    $
                    17,909





The
following table summarized the estimated fair value of net assets
acquired:





(Amounts
      in thousands)AssetsCash
      and cash equivalents
                  
                  $
                  1,387Interest-bearing
      deposits in other banks
                  
                  
                  68Federal
      funds sold
                  
                  
                  2,488Investment
      securities
                  
                  
                  13,122Loans,
      net of allowances for loan losses
                  
                  
                  104,752Premises
      and equipment-net
                  
                  
                  3,292Accrued
      interest receivable
                  
                  
                  596Cash
      surrender value of bank-owned life insurance
                  
                  
                  2,950Goodwill
      and other intangibles
                  
                  
                  19,838Other
      assets
                  
                  
                  1,065Total
      Assets
                  
                  $
                  149,558LiabilitiesDeposits
                  
                  $
                  109,672Borrowings
                  
                  
                  5,908Other
      liabilities
                  
                  
                  413Total
      Liabilities
                  
                  $
                  115,993Fair
      Value of Net Assets Acquired
                  
                  $
                  33,565





Assets
and liabilities of Pocono are recorded at estimated fair values as of the
acquisition date under the required purchase accounting method and the results
of Pocono’s operations are included in income from November 1, 2007 to December
31, 2007. The fair values of acquired assets and liabilities, including
identifiable intangible assets, are finalized as quickly as possible following
an acquisition. The purchase price allocations are complete.


44


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued





The
following unaudited pro forma consolidated financial information presents the
combined results of operations of the Corporation as if the Pocono acquisition
had occurred as of the beginning of 2007 and 2006, respectively:





(Dollars in thousands, except per share amounts)
                
                For the Year Ended2007
                
                
                2006Net
      interest income
                
                $
                17,100
                
                
                $
                17,182Provision
      for loan losses
                
                
                206
                
                
                
                580Net
      interest income after provision for loan losses
                
                
                16,894
                
                
                
                16,602Noninterest
      income
                
                
                4,658
                
                
                
                4,245Noninterest
      expense
                
                
                13,575
                
                
                
                12,897Income
      before income tax expense
                
                
                7,977
                
                
                
                7,950Income
      tax expense
                
                
                1,206
                
                
                
                1,415Net
      Income
                
                $
                6,771
                
                
                $
                6,535Net
      Income Per Common ShareBasic
                
                $
                1.21
                
                
                $
                1.19Diluted
                
                $
                1.21
                
                
                $
                1.19Average
      Common Shares OutstandingBasic
                
                
                5,606,316
                
                
                
                5,503,359Diluted
                
                
                5,611,990
                
                
                
                5,509,996





The pro
forma results include amortization of fair value adjustments on loans, deposits,
and debt, and amortization of newly acquired intangibles. The pro forma number
of average common shares outstanding includes adjustments for shares issued for
the acquisitions and the impact of additional dilutive securities but does not
assume any incremental share repurchases. The pro forma results presented do not
reflect cost savings or revenue enhancements anticipated from the acquisition
and are not necessarily indicative of what actually would have occurred if the
acquisition had been completed as of the beginning of the periods presented, nor
are they necessarily indicative of future consolidated results.





NOTE
3  —   RESTRICTED CASH
BALANCES





The Bank
is required to maintain certain average reserve balances as established by the
Federal Reserve Bank. The amount of those reserve balances for the reserve
computation period which included December 31, 2008, was $1,464,000, which was
satisfied through the restriction of vault cash. In addition, the Bank maintains
a clearing balance at the Federal Reserve Bank to offset specific charges for
services. At December 31, 2008, the amount of this balance was
$1,764,000.


45


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued





NOTE
4  —   INVESTMENT
SECURITIES





The
amortized cost, related estimated fair value, and unrealized gains and losses
for investment securities classified as “Available-For-Sale” or
“Held-to-Maturity” were as follows at December 31, 2008 and 2007:





Available-for-Sale Securities(Amounts
      in thousands)
                
                
                
                
                Gross
                
                
                Gross
                
                
                EstimatedAmortized
                
                
                Unrealized
                
                
                Unrealized
                
                
                FairDecember
      31, 2008:
                
                Cost
                
                
                Gains
                
                
                Losses
                
                
                ValueObligations
      of U.S. Government Corporations and Agencies:Mortgage-backed
                
                $
                64,966
                
                
                $
                2,032
                
                
                $
                —
                
                
                $
                66,998Other
                
                
                11,011
                
                
                
                335
                
                
                
                —
                
                
                
                11,346Obligations
      of state and political subdivisions
                
                
                142,805
                
                
                
                308
                
                
                
                (9,652
                )
                
                
                133,461Corporate
      securities
                
                
                19,650
                
                
                
                198
                
                
                
                (67
                )
                
                
                19,781Marketable
      equity securities
                
                
                2,605
                
                
                
                253
                
                
                
                (947
                )
                
                
                1,911Restricted
      equity securities
                
                
                6,678
                
                
                
                —
                
                
                
                —
                
                
                
                6,678Total
                
                $
                247,715
                
                
                $
                3,126
                
                
                $
                (10,666
                )
                
                $
                240,175





Held-to-Maturity Securities(Amounts
      in thousands)
                    
                    
                    
                    
                    Gross
                    
                    
                    Gross
                    
                    
                    EstimatedAmortized
                    
                    
                    Unrealized
                    
                    
                    Unrealized
                    
                    
                    FairDecember
      31, 2008:
                    
                    Cost
                    
                    
                    Gains
                    
                    
                    Losses
                    
                    
                    ValueObligations
      of U.S. Government Corporations and Agencies:Mortgage-backed
                    
                    $
                    176
                    
                    
                    $
                    —
                    
                    
                    $
                    (3
                    )
                    
                    $
                    173Other
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —Obligations
      of state and political subdivisions
                    
                    
                    2,814
                    
                    
                    
                    4
                    
                    
                    
                    (85
                    )
                    
                    
                    2,733Total
                    
                    $
                    2,990
                    
                    
                    $
                    4
                    
                    
                    $
                    (88
                    )
                    
                    $
                    2,906





Available-for-Sale
    Securities(Amounts
      in thousands)
                
                
                
                
                Gross
                
                
                Gross
                
                
                EstimatedAmortized
                
                
                Unrealized
                
                
                Unrealized
                
                
                FairDecember
      31, 2007:
                
                Cost
                
                
                Gains
                
                
                Losses
                
                
                ValueObligations
      of U.S. Government Corporations and Agencies:Mortgage-backed
                
                $
                116,693
                
                
                $
                793
                
                
                $
                (467
                )
                
                $
                117,019Other
                
                
                32,348
                
                
                
                248
                
                
                
                (8
                )
                
                
                32,588Obligations
      of state and political subdivisions
                
                
                75,347
                
                
                
                442
                
                
                
                (1,430
                )
                
                
                74,359Corporate
      securities
                
                
                8,367
                
                
                
                163
                
                
                
                —
                
                
                
                8,530Marketable
      equity securities
                
                
                2,914
                
                
                
                508
                
                
                
                (506
                )
                
                
                2,916Restricted
      equity securities
                
                
                6,109
                
                
                
                —
                
                
                
                —
                
                
                
                6,109Total
                
                $
                241,778
                
                
                $
                2,154
                
                
                $
                (2,411
                )
                
                $
                241,521


46


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued





Held-to-Maturity Securities(Amounts
      in thousands)
                    
                    
                    
                    
                    Gross
                    
                    
                    Gross
                    
                    
                    EstimatedAmortized
                    
                    
                    Unrealized
                    
                    
                    Unrealized
                    
                    
                    FairDecember
      31, 2007:
                    
                    Cost
                    
                    
                    Gains
                    
                    
                    Losses
                    
                    
                    ValueObligations
      of U.S. Government Corporations and Agencies:Mortgage-backed
                    
                    $
                    191
                    
                    
                    $
                    —
                    
                    
                    $
                    (1
                    )
                    
                    $
                    190Other
                    
                    
                    2,000
                    
                    
                    
                    7
                    
                    
                    
                    —
                    
                    
                    
                    2,007Obligations
      of state and political subdivisions
                    
                    
                    2,347
                    
                    
                    
                    9
                    
                    
                    
                    —
                    
                    
                    
                    2,356Total
                    
                    $
                    4,538
                    
                    
                    $
                    16
                    
                    
                    $
                    (1
                    )
                    
                    $
                    4,553





Securities
Available-for-Sale with an aggregate fair value of $140,811,000 in 2008 and
$99,997,000 in 2007; and securities Held-to-Maturity with an aggregate book
value of $2,523,000 in 2008 and $2,539,000 in 2007, were pledged to secure
public funds, trust funds, securities sold under agreements to repurchase, FHLB
advances and other balances of $57,231,000 in 2008 and $57,991,000 in 2007 as
required by law.





The
amortized cost, estimated fair value and weighted average yield of debt
securities, by contractual maturity, are shown below at December 31, 2008.
Expected maturities will differ from contractual maturities because borrowers
may have the right to call or prepay obligations with or without call or
prepayment penalties.





(Amounts
in thousands)


December 31, 2008U.S. Government
                                              
                                              
                                              ObligationsAgency &
                                              
                                              
                                              of State
                                              
                                              
                                              Marketable
                                              
                                              
                                              RestrictedCorporation
                                              
                                              
                                              & Political
                                              
                                              
                                              Equity
                                              
                                              
                                              Equity
                                              
                                              
                                              CorporateObligations1
                                              
                                              
                                              Subdivisions2
                                              
                                              
                                              Securities3
                                              
                                              
                                              Securities3
                                              
                                              
                                              SecuritiesAvailable-For-Sale:Within
      1 Year:Amortized
      cost
                                              
                                              $
                                              499
                                              
                                              
                                              $
                                              —
                                              
                                              
                                              $
                                              —
                                              
                                              
                                              $
                                              —
                                              
                                              
                                              $
                                              1,493Estimated
      fair value
                                              
                                              
                                              503
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              1,467Weighted
      average yield
                                              
                                              
                                              4.07
                                              %
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              4.60
                                              %1 -
      5 Years:Amortized
      cost
                                              
                                              
                                              1,100
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              18,157Estimated
      fair value
                                              
                                              
                                              1,120
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              18,314Weighted
      average yield
                                              
                                              
                                              5.59
                                              %
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              5.69
                                              %5 -
      10 Years:Amortized
      cost
                                              
                                              
                                              4,709
                                              
                                              
                                              
                                              5,208
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Estimated
      fair value
                                              
                                              
                                              4,865
                                              
                                              
                                              
                                              5,225
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Weighted
      average yield
                                              
                                              
                                              5.35
                                              %
                                              
                                              
                                              4.87
                                              %
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —After
      10Amortized
      cost
                                              
                                              
                                              69,669
                                              
                                              
                                              
                                              137,597
                                              
                                              
                                              
                                              2,605
                                              
                                              
                                              
                                              6,678
                                              
                                              
                                              
                                              —Estimated
      fair value
                                              
                                              
                                              71,856
                                              
                                              
                                              
                                              128,236
                                              
                                              
                                              
                                              1,911
                                              
                                              
                                              
                                              6,678
                                              
                                              
                                              
                                              —Weighted
      average yield
                                              
                                              
                                              5.57
                                              %
                                              
                                              
                                              4.97
                                              %
                                              
                                              
                                              3.53
                                              %
                                              
                                              
                                              2.85
                                              %
                                              
                                              
                                              —Total:Amortized
      cost
                                              
                                              $
                                              75,977
                                              
                                              
                                              $
                                              142,805
                                              
                                              
                                              $
                                              2,605
                                              
                                              
                                              $
                                              6,678
                                              
                                              
                                              $
                                              19,650Estimated
      fair value
                                              
                                              
                                              78,344
                                              
                                              
                                              
                                              133,461
                                              
                                              
                                              
                                              1,911
                                              
                                              
                                              
                                              6,678
                                              
                                              
                                              
                                              19,781Weighted
      average yield
                                              
                                              
                                              5.56
                                              %
                                              
                                              
                                              4.97
                                              %
                                              
                                              
                                              3.53
                                              %
                                              
                                              
                                              2.85
                                              %
                                              
                                              
                                              5.26
                                              %


_______________________





1Mortgage-backed
securities are allocated for maturity reporting at their original maturity
date.


2Average
yields on tax-exempt obligations of state and political subdivisions have been
computed on a tax-equivalent basis using a 34% tax rate.


3Marketable
equity securities and restricted equity securities are not considered to have
defined maturities and are included in the after ten year
category.


47


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued





(Amounts
in thousands)


December 31, 2008U.S. Government
                                              
                                              
                                              ObligationsAgency &
                                              
                                              
                                              of State
                                              
                                              
                                              Marketable
                                              
                                              
                                              RestrictedCorporation
                                              
                                              
                                              & Political
                                              
                                              
                                              Equity
                                              
                                              
                                              Equity
                                              
                                              
                                              CorporateObligations1
                                              
                                              
                                              Subdivisions2
                                              
                                              
                                              Securities3
                                              
                                              
                                              Securities3
                                              
                                              
                                              SecuritiesHeld-To-Maturity:Within
      1 Year:Amortized
      cost
                                              
                                              $
                                              —
                                              
                                              
                                              $
                                              —
                                              
                                              
                                              $
                                              —
                                              
                                              
                                              $
                                              —
                                              
                                              
                                              $
                                              —Estimated
      fair value
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Weighted
      average yield
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —1
      - 5 Years:Amortized
      cost
                                              
                                              
                                              —
                                              
                                              
                                              
                                              1,347
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Estimated
      fair value
                                              
                                              
                                              —
                                              
                                              
                                              
                                              1,316
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Weighted
      average yield
                                              
                                              
                                              —
                                              
                                              
                                              
                                              3.97
                                              %
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —5
      - 10 Years:Amortized
      cost
                                              
                                              
                                              176
                                              
                                              
                                              
                                              1,000
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Estimated
      fair value
                                              
                                              
                                              173
                                              
                                              
                                              
                                              1,001
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Weighted
      average yield
                                              
                                              
                                              3.79
                                              %
                                              
                                              
                                              4.05
                                              %
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —After
      10 Years:Amortized
      cost
                                              
                                              
                                              —
                                              
                                              
                                              
                                              467
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Estimated
      fair value
                                              
                                              
                                              —
                                              
                                              
                                              
                                              416
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Weighted
      average yield
                                              
                                              
                                              —
                                              
                                              
                                              
                                              4.85
                                              %
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Total:Amortized
      cost
                                              
                                              $
                                              176
                                              
                                              
                                              $
                                              2,814
                                              
                                              
                                              $
                                              —
                                              
                                              
                                              $
                                              —
                                              
                                              
                                              $
                                              —Estimated
      fair value
                                              
                                              
                                              173
                                              
                                              
                                              
                                              2,733
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Weighted
      average yield
                                              
                                              
                                              3.79
                                              %
                                              
                                              
                                              4.14
                                              %
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —


_______________________





1Mortgage-backed
securities are allocated for maturity reporting at their original maturity
date.


2Average
yields on tax-exempt obligations of state and political subdivisions have been
computed on a tax-equivalent basis using a  34% tax rate.


3Marketable
equity securities and restricted equity securities are not considered to have
defined maturities and are included in the after ten year category.





Restricted
equity securities consist of stock in the Federal Home Loan Bank of Pittsburgh
(FHLB), Federal Reserve Bank (FRB) and Atlantic Central Bankers Bank (ACBB) and
do not have a readily determinable fair value for purposes of SFAS 115, because
their ownership is restricted and they can be sold back only to the FHLB, FRB,
ACBB or to another member institution. Therefore, these securities are
classified as restricted equity investment securities, carried at cost, and
evaluated for impairment.





There
were no aggregate investments with a single issuer (excluding the U.S.
Government and its agencies) which exceeded ten percent of consolidated
shareholders’ equity at December 31, 2008. The quality rating of the obligations
of state and political subdivisions are generally investment grade, as rated by
Moody’s or Standard and Poors. The typical exceptions are local issues which are
not rated, but are secured by the full faith and credit obligations of the
communities that issued these securities. The state and political subdivision
investments are actively traded in a liquid market.





Proceeds
from sale of investments in Available-for-Sale debt and equity securities during
2008, 2007 and 2006 were $83,626,000, $83,255,000 and $103,736,000,
respectively. Gross gains realized on these sales were $737,000, $1,117,000 and
$1,441,000, respectively. Gross losses on these sales were $885,000, $631,000
and $1,054,000, respectively. Included in gross losses in 2008 is an impairment
loss on certain equity securities in the amount of $437,000.


48


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued





Proceeds
from sale of investments in Held-To-Maturity debt and equity securities during
2008, 2007, and 2006 were $0, $375,000 and $201,000,
respectively.  Gross losses on these sales were $0, $3,000 and $6,000,
respectively and there were no gains realized during these periods.





In
accordance with disclosures required by EITF No. 03-1, the summary below shows
the gross unrealized losses and fair value of the Bank’s investments, aggregated
by investment category, that individual securities have been in a continuous
unrealized loss position for less than 12 months or more than 12 months as of
December 31, 2008 and 2007:





December
      31, 2008Less Than 12 Months
                
                
                12 Months or More
                
                
                TotalFair
                
                
                Unrealized
                
                
                Fair
                
                
                Unrealized
                
                
                Fair
                
                
                Unrealized(Amounts
      in thousands)
                
                Value
                
                
                Loss
                
                
                Value
                
                
                Loss
                
                
                Value
                
                
                LossDirect
      obligations of the U.S. Government
                
                $
                —
                
                
                $
                —
                
                
                $
                —
                
                
                $
                —
                
                
                $
                —
                
                
                $
                —Federal
      Agency Backed Securities
                
                
                —
                
                
                
                —
                
                
                
                173
                
                
                
                2
                
                
                
                173
                
                
                
                2Municipal
      Bonds
                
                
                104,558
                
                
                
                7,963
                
                
                
                6,512
                
                
                
                1,774
                
                
                
                111,070
                
                
                
                9,737Corporate
      Securities
                
                
                7,039
                
                
                
                68
                
                
                
                —
                
                
                
                —
                
                
                
                7,039
                
                
                
                68Equities
                
                
                428
                
                
                
                119
                
                
                
                728
                
                
                
                828
                
                
                
                1,156
                
                
                
                947$
                112,025
                
                
                $
                8,150
                
                
                $
                7,413
                
                
                $
                2,604
                
                
                $
                119,438
                
                
                $
                10,754





December 31, 2007Less Than 12 Months
                
                
                12 Months or More
                
                
                TotalFair
                
                
                Unrealized
                
                
                Fair
                
                
                Unrealized
                
                
                Fair
                
                
                Unrealized(Amounts
      in thousands)
                
                Value
                
                
                Loss
                
                
                Value
                
                
                Loss
                
                
                Value
                
                
                LossDirect
      obligations of the U.S. Government
                
                $
                13,993
                
                
                $
                8
                
                
                $
                —
                
                
                $
                —
                
                
                $
                13,993
                
                
                $
                8Federal
      Agency Backed Securities
                
                
                —
                
                
                
                —
                
                
                
                32,949
                
                
                
                468
                
                
                
                32,949
                
                
                
                468Municipal
      Bonds
                
                
                38,818
                
                
                
                1,149
                
                
                
                2,880
                
                
                
                281
                
                
                
                41,698
                
                
                
                1,430Equities
                
                
                1,498
                
                
                
                453
                
                
                
                174
                
                
                
                53
                
                
                
                1,672
                
                
                
                506$
                54,309
                
                
                $
                1,610
                
                
                $
                36,003
                
                
                $
                802
                
                
                $
                90,312
                
                
                $
                2,412





The
Corporation invests in various forms of agency debt including mortgage backed
securities and callable debt. The mortgage backed securities are issued by FHLMC
(Federal Home Loan Mortgage Corporation) of FNMA (Federal National Mortgage
Association). The municipal securities consist of general obligations and
revenue bonds. The equity securities consist of stocks in other bank holding
companies.  The fair market value of the above securities is
influenced by market interest rates, prepayment speeds on mortgage securities,
bid to offer spreads in the market place and credit premiums for various types
of agency debt. These factors change continuously and therefore the market value
of these securities may be higher or lower that the Corporation’s carrying value
at any measurement date. Management does not believe any of their 162 securities
in an unrealized position as of December 31, 2008 represents an
other-than-temporary impairment. The Corporation has the ability to hold the
remaining securities contained in the above table for a time necessary to
recover the cost.





Securities
with an unrealized loss that are determined to be other-than-temporary are
written down to fair value, with the write-down recorded as a realized loss
included in securities gains (losses).  During 2008, the Corporation
recorded an other-than-temporary impairment loss totaling $437,000 related to
investments in certain equity securities. The fair value of those securities was
approximately $81,000 as of December 31, 2008.


49


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued





Assets
Measured at Fair Value on a Recurring Basis





The
Corporation measures certain assets at fair value on a recurring basis. Fair
value is defined as a price that would be received to sell an asset in an
orderly transaction between market participants at the measurement date. SFAS
157 establishes a framework for measuring fair value that includes a hierarchy
used to classify the inputs used in measuring fair value. The hierarchy
prioritizes the inputs used in determining valuations into three levels. The
level in the fair value hierarchy within which the fair value measurement falls
is determined based on the lowest level input that is significant to the fair
value measurement. The levels of the fair value hierarchy are as
follows:





A.
            Level 1: Fair
      value is based on unadjusted quoted prices in active markets that are
      accessible to the Bank for identical assets. These generally provide the
      most reliable evidence and are used to measure fair value whenever
      available.


B.
            Level 2: Fair
      value is based on significant inputs, other than Level 1 inputs, that are
      observable either directly or indirectly for substantially the full term
      of the asset through corroboration with observable market date. Level 2
      inputs include quoted market prices in active markets for similar assets,
      quoted market prices that are not active for identical or similar assets
      and other observable inputs.


C.
            Level 3: Fair
      value is based on significant unobservable inputs. Examples of valuation
      methodologies that would result in Level 3 classification include option
      pricing models, discounted cash flows and other similar
      techniques.





At
December 31, 2008 investments measured at fair value on a recurring basis and
the valuation methods used are as follows:





Level 1
                
                
                Level 2
                
                
                Level 3
                
                
                TotalAvailable
      for Sale SecuritiesObligations
      of US Government AgenciesMortgaged-backed
                
                $
                —
                
                
                $
                66,998
                
                
                $
                —
                
                
                $
                66,998Other
                
                
                —
                
                
                
                11,346
                
                
                
                —
                
                
                
                11,346Obligations
      of state and political subdivisions
                
                
                —
                
                
                
                133,461
                
                
                
                —
                
                
                
                133,461Corporate
      securities
                
                
                —
                
                
                
                19,781
                
                
                
                —
                
                
                
                19,781Equity
      securities
                
                
                1,911
                
                
                
                —
                
                
                
                —
                
                
                
                1,911Restricted
      equity securities
                
                
                —
                
                
                
                6,678
                
                
                
                —
                
                
                
                6,678$
                1,911
                
                
                $
                238,264
                
                
                $
                —
                
                
                $
                240,175





The
estimated fair values of equity securities classified as Level 1 are derived
from quoted market prices in active markets; these assets consist mainly of
stocks held in other banks. The estimated fair values of all debt securities
classified as Level 2 are obtained from nationally-recognized third-party
pricing agencies. The estimated fair values are derived primarily from cash flow
models, which include assumptions for interest rates, credit losses, and
prepayment speeds. The significant inputs utilized in the cash flow models are
based on market data obtained from sources independent of the Bank (observable
inputs), and are therefore classified as Level 2 within the fair value
hierarchy.


50


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued





NOTE
5  —   LOANS





Major
classifications of loans at December 31, 2008 and 2007 consisted
of:





(Amounts
in thousands)


2008
                    
                    
                    2007Commercial,
      Financial, and Agricultural
                    
                    $
                    33,104
                    
                    
                    $
                    29,129Tax-exempt
                    
                    
                    18,920
                    
                    
                    
                    10,899Real
      estate mortgages - Held-for-sale
                    
                    
                    3,613
                    
                    
                    
                    334Real
      estate mortgages - Consumer
                    
                    
                    132,675
                    
                    
                    
                    130,531Real
      estate mortgages - Commercial
                    
                    
                    206,095
                    
                    
                    
                    190,803Consumer
                    
                    
                    15,291
                    
                    
                    
                    16,712Gross
      loans
                    
                    $
                    409,698
                    
                    
                    $
                    378,408Add
      (deduct): Unearned discount
                    
                    
                    (1,711
                    )
                    
                    
                    (2,074
                    )Net deferred loan fees and costs
                    
                    
                    380
                    
                    
                    
                    269Loans,
      net of unearned income
                    
                    $
                    408,367
                    
                    
                    $
                    376,603





Changes
in the allowance for loan losses for the years ended December 31, 2008, 2007 and
2006, were as follows:





(Amounts
in thousands)


2008
                    
                    
                    2007
                    
                    
                    2006Balance,
      January 1
                    
                    $
                    5,046
                    
                    
                    $
                    3,671
                    
                    
                    $
                    3,676Provision
      charged to operations
                    
                    
                    700
                    
                    
                    
                    150
                    
                    
                    
                    500Loans
      charged off
                    
                    
                    (739
                    )
                    
                    
                    (236
                    )
                    
                    
                    (786
                    )Recoveries
                    
                    
                    188
                    
                    
                    
                    179
                    
                    
                    
                    281Allowance
      purchased
                    
                    
                    —
                    
                    
                    
                    1,282
                    
                    
                    
                    —Balance,
      December 31
                    
                    $
                    5,195
                    
                    
                    $
                    5,046
                    
                    
                    $
                    3,671





Non-accrual
loans at December 31, 2008, 2007 and 2006 were $1,718,000, $3,208,000 and
$1,704,000, respectively. The gross interest that would have been recorded if
these loans had been current in accordance with their original terms and the
amounts actually recorded in income were as follows:





(Amounts
in thousands)


2008
                    
                    
                    2007
                    
                    
                    2006Gross
      interest due under terms
                    
                    $
                    145
                    
                    
                    $
                    258
                    
                    
                    $
                    133Amount
      included in income
                    
                    
                    (94
                    )
                    
                    
                    (144
                    )
                    
                    
                    (14
                    )Interest
      income not recognized
                    
                    $
                    51
                    
                    
                    $
                    114
                    
                    
                    $
                    119





At
December 31, 2008, 2007 and 2006 the recorded investment in impaired loans as
defined by SFAS 114 was $2,349,000, $3,208,000 and $1,704,000 and the impaired
loans allowances were $417,000, $492,000 and $131,000, respectively at December
31, 2008, 2007 and 2006. The average recorded balance in impaired loans during
the year ended December 31, 2008, 2007 and 2006 was approximately $4,246,000,
$1,837,000 and $1,937,000, respectively.





Loans
past-due 90 days or more and still accruing interest were $15,000 at December
31, 2008 and $185,000 at December 31, 2007.





At
December 31, 2008, there were no significant commitments to lend additional
funds with respect to non-accrual and restructured loans.


51


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued





NOTE
6  —   MORTGAGE SERVICING
RIGHTS





The
mortgage loans sold serviced for others are not included in the accompanying
consolidated balance sheets. The unpaid principal balances of mortgage loans
serviced for others were $47,303,000 and $44,769,000 at December 31, 2008 and
2007, respectively. The balances of amortized capitalized mortgage servicing
rights, included in other assets at December 31, 2008 and 2007, were $277,000
and $297,000, respectively.





The
following summarizes mortgage servicing rights capitalized and amortized along
with the aggregate activity in the related valuation allowances:





(Amounts
in thousands)


2008
                    
                    
                    2007
                    
                    
                    2006Balance,
      January 1
                    
                    $
                    297
                    
                    
                    $
                    254
                    
                    
                    $
                    268Servicing
      asset additions
                    
                    
                    63
                    
                    
                    
                    103
                    
                    
                    
                    43Amortization
                    
                    
                    (83
                    )
                    
                    
                    (60
                    )
                    
                    
                    (57
                    )Balance,
      December 31
                    
                    $
                    277
                    
                    
                    $
                    297
                    
                    
                    $
                    254





Custodial
escrow balances maintained in connection with the foregoing loan servicing, and
included in demand deposits, were approximately $32,000 and $33,000 at December
31, 2008 and 2007, respectively.





NOTE
7  —   PREMISES AND
EQUIPMENT





A summary
of premises and equipment at December 31, 2008 and 2007 follows:





(Amounts
in thousands)


2008
                    
                    
                    2007Land
                    
                    $
                    1,746
                    
                    
                    $
                    1,746Buildings
                    
                    
                    8,822
                    
                    
                    
                    7,832Leasehold
      improvements
                    
                    
                    391
                    
                    
                    
                    391Equipment
                    
                    
                    6,146
                    
                    
                    
                    6,40117,105
                    
                    
                    
                    16,370Less:  Accumulated
      depreciation
                    
                    
                    7,936
                    
                    
                    
                    7,884Total
                    
                    $
                    9,169
                    
                    
                    $
                    8,486





Depreciation
amounted to $681,000 for 2008, $472,000 for 2007 and $442,000 for
2006.





The
banking subsidiary leases land and a bank building in Stroudsburg, Pennsylvania,
under a lease expiring in 2017 (See Note 15). Included in buildings above is the
bank building held under a capital lease with a cost of $953,000 and accumulated
amortization of $528,000 and $481,000 at December 31, 2008 and 2007,
respectively. Amortization on the bank building held under the capital lease was
$47,000 and $8,000 for the years ended December 31, 2008 and 2007,
respectively.


52


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued





NOTE
8  —   GOODWILL, OTHER INTANGIBLE ASSETS,
AND PREMIUM DISCOUNTS





Goodwill,
other intangible assets, and premium discounts were comprised of the following
at December 31, 2008 and 2007:





(Amounts
in thousands)


Gross
                
                
                AccumulatedCarrying Amount
                
                
                Amortization/(Accretion)2008
                
                
                2007
                
                
                2008
                
                
                2007Unamortized
      intangible asset:Goodwill
                
                $
                19,133
                
                
                $
                18,981
                
                
                $
                —
                
                
                $
                —Core
      deposit intangibles
                
                $
                2,218
                
                
                $
                2,218
                
                
                $
                399
                
                
                $
                109Premium
      discount (negative premium) on acquired certificates of
      deposit
                
                $
                (385
                )
                
                $
                (385
                )
                
                $
                (362
                )
                
                $
                (253
                )





Amortization
expense of the core deposit intangibles was $289,000, $61,000 and $16,000 for
the years ended


December
31, 2008, 2007 and 2006, respectively. Accretion of the premium discount
(negative premium) of the acquired certificates of deposit was $109,000, $36,000
and $15,000 for the years ended December 31, 2008, 2007 and 2006,
respectively.





Estimated
amortization/accretion is as follows for the years ending December
31:





(Amounts
in thousands)





Amortization
                  
                  
                  Accretion of Premium Discountof Core
                  
                  
                  (Negative Premium)Deposit Intangible
                  
                  
                  on Certificates of Deposit2009
                  
                  $
                  289
                  
                  
                  $
                  (21
                  )2010
                  
                  
                  289
                  
                  
                  
                  (2
                  )2011
                  
                  
                  289
                  
                  
                  
                  —2012
                  
                  
                  283
                  
                  
                  
                  —2013
                  
                  
                  273
                  
                  
                  
                  —





NOTE
9  —   DEPOSITS





Major
classifications of deposits at December 31, 2008 and 2007 consisted
of:





(Amounts
in thousands)





2008
                
                
                2007Demand
      - non-interest bearing
                
                $
                58,178
                
                
                $
                58,844Demand
      - interest bearing
                
                
                83,912
                
                
                
                88,628Savings
                
                
                94,700
                
                
                
                93,168Time,
      $100,000 and over
                
                
                87,259
                
                
                
                72,212Other
      time
                
                
                180,584
                
                
                
                180,189Total
      deposits
                
                $
                504,633
                
                
                $
                493,041




53


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued





The
following is a schedule reflecting classification and remaining maturities of
time deposits of $100,000 and over at December 31, 2008:





(Amounts
in thousands)


2009
                  
                  $
                  62,1232010
                  
                  
                  10,8262011
                  
                  
                  2,1482012
                  
                  
                  7,3932013
                  
                  
                  4,769$
                  87,259





Interest
expense related to time deposits of $100,000 or more was $3,408,000 in 2008,
$2,520,000 in 2007 and $1,907,000 in 2006.





In
November 2007, approximately $109,672,000 of deposit accounts were assumed
through the acquisition of Pocono Community Bank (See Notes 2 and
13).





NOTE
10  —   SHORT-TERM
BORROWINGS





Federal
funds purchased, securities sold under agreements to repurchase and Federal Home
Loan Bank advances generally represent overnight or less than 30-day borrowings.
U.S. Treasury tax and loan notes for collections made by the Bank are payable on
demand. Short-term borrowings consisted of the following at December 31, 2008
and 2007:





(Amounts
      in thousands)
                
                2008MaximumEnding
                
                
                Average
                
                
                Month
      End
                
                
                AverageBalance
                
                
                Balance
                
                
                Balance
                
                
                RateFederal
      funds purchased and securities sold under agreements to
      repurchase
                
                $
                20,572
                
                
                $
                18,245
                
                
                $
                26,279
                
                
                
                2.62
                %Federal
      Home Loan Bank
                
                
                32,200
                
                
                
                11,265
                
                
                
                32,500
                
                
                
                1.59
                %U.S.
      Treasury tax and loan notes
                
                
                2,560
                
                
                
                618
                
                
                
                2,559
                
                
                
                1.82
                %Total
                
                $
                55,332
                
                
                $
                30,128
                
                
                $
                61,338
                
                
                
                1.84
                %





(Amounts in thousands)
                
                2007MaximumEnding
                
                
                Average
                
                
                Month End
                
                
                AverageBalance
                
                
                Balance
                
                
                Balance
                
                
                RateFederal
      funds purchased and securities sold under agreements to
      repurchase
                
                $
                16,386
                
                
                $
                14,563
                
                
                $
                23,842
                
                
                
                4.07
                %Federal
      Home Loan Bank
                
                
                29,500
                
                
                
                14,136
                
                
                
                29,500
                
                
                
                4.99
                %U.S.
      Treasury tax and loan notes
                
                
                1,463
                
                
                
                537
                
                
                
                1,686
                
                
                
                5.47
                %Total
                
                $
                47,349
                
                
                $
                29,236
                
                
                $
                55,028
                
                
                
                5.54
                %





NOTE
11  —   LONG-TERM
BORROWINGS





Long-term
borrowings are comprised of advances from the Federal Home Loan Bank (FHLB) and
a capital lease assumed as a result of the acquisition of Pocono Community Bank
in the amount of $811,000. Long term capital lease scheduled maturities as of
December 31, 2008 are: $51,000 in 2009, $55,000 in 2010, $60,000 in 2011,
$67,000 in 2012, and $524,000 thereafter for a total balance of $757,000 as of
December 31, 2008.


54


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued





Under
terms of a blanket agreement, collateral for the loans is secured by certain
qualifying assets of the Corporation's banking subsidiary with
FHLB.  The principal assets are real estate mortgages with a carrying
value of $345,893,000 and certain investment securities with a carrying value of
$78,344,000 at December 31, 2008.





A
schedule of long-term borrowings by maturity as of December 31, 2008 and 2007
follows:





(Amounts
in thousands)


2008
                      
                      
                      2007Due
      2008, 3.54% to 5.48%
                      
                      $
                      —
                      
                      
                      $
                      9,030Due
      2009, 3.87% to 5.01%
                      
                      
                      12,000
                      
                      
                      
                      12,000Due
      2010, 4.95% to 6.76%
                      
                      
                      23,556
                      
                      
                      
                      23,591Due
      2011, 2.73% to 5.03%
                      
                      
                      12,000
                      
                      
                      
                      7,000Due
      2012, 4.77% to 4.93%
                      
                      
                      10,000
                      
                      
                      
                      10,000Due
      2013, 3.15% to 4.60%
                      
                      
                      10,000
                      
                      
                      
                      —Due
      2014, 5.41%
                      
                      
                      3,750
                      
                      
                      
                      3,750Due
      2018, 3.91% to 4.86%
                      
                      
                      8,000
                      
                      
                      
                      —Due
      2028, 5.14%
                      
                      
                      2,000
                      
                      
                      
                      —$
                      81,306
                      
                      
                      $
                      65,371





NOTE
12  —   INCOME TAXES





The
current and deferred components of the income tax provision (benefit) consisted
of the following:





(Amounts
in thousands)


2008
                
                
                2007
                
                
                2006FederalCurrent
                
                $
                1,865
                
                
                $
                1,456
                
                
                $
                1,417Deferred
      (benefit)
                
                
                (419
                )
                
                
                (104
                )
                
                
                (263
                )$
                1,446
                
                
                $
                1,352
                
                
                $
                1,154StateCurrent
                
                
                —
                
                
                
                39
                
                
                $
                34Deferred
                
                
                (52
                )
                
                
                —
                
                
                
                —$
                (52
                )
                
                $
                39
                
                
                $
                34Total
      provision for income taxes
                
                $
                1,394
                
                
                $
                1,391
                
                
                $
                1,188





The
following is a reconciliation between the actual provision for federal income
taxes and the amount of federal income taxes which would have been provided at
the statutory rate of 34%:





(Amounts
      in thousands)
                
                2008
                
                
                2007
                
                
                2006Amount
                
                
                Rate
                
                
                Amount
                
                
                Rate
                
                
                Amount
                
                
                RateProvision
      at statutory rate
                
                $
                3,041
                
                
                
                34.0
                %
                
                $
                2,556
                
                
                
                34.0
                %
                
                $
                2,508
                
                
                
                34.0
                %Tax-exempt
      income
                
                
                (1,397
                )
                
                
                (15.6
                )
                
                
                (1,060
                )
                
                
                (14.1
                )
                
                
                (1,276
                )
                
                
                (17.3
                )Non-deductible
      expenses
                
                
                177
                
                
                
                2.0
                
                
                
                165
                
                
                
                2.2
                
                
                
                176
                
                
                
                2.4Tax
      credit from limited
      partnership Less amortization - net
                
                
                (136
                )
                
                
                (1.5
                )
                
                
                (79
                )
                
                
                (1.1
                )
                
                
                (62
                )
                
                
                (.8
                )Bank
      owned life insurance income - net
                
                
                (240
                )
                
                
                (2.7
                )
                
                
                (190
                )
                
                
                (2.5
                )
                
                
                (160
                )
                
                
                (2.2
                )Other-net
                
                
                1
                
                
                
                —
                
                
                
                (40
                )
                
                
                (.5
                )
                
                
                (32
                )
                
                
                (.5
                )Applicable
      federal income tax and rate
                
                $
                1,446
                
                
                
                16.2
                %
                
                $
                1,352
                
                
                
                18.0
                %
                
                $
                1,154
                
                
                
                15.6
                %


55


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued





Total
federal income tax attributable to realized security gains and losses was
$98,000 in 2008, $164,000 in 2007 and $130,000 in 2006.





The
deferred tax assets and liabilities resulting from temporary timing differences
have been netted to reflect a net deferred tax asset (liability) included in
other assets or other liabilities in these consolidated financial statements.
The components of the net deferred tax asset (liability) at December 31, 2008
and 2007, are as follows:





(Amounts
in thousands)


2008
                  
                  
                  2007Deferred
      Tax Assets:Allowance
      for loan losses
                  
                  $
                  1,742
                  
                  
                  $
                  1,631Deferred
      compensation
                  
                  
                  412
                  
                  
                  
                  364Deferred
      health benefits
                  
                  
                  —
                  
                  
                  
                  2Contributions
                  
                  
                  5
                  
                  
                  
                  13Non-accrual
      interest
                  
                  
                  30
                  
                  
                  
                  41Leases
                  
                  
                  114
                  
                  
                  
                  114Limited
      partnership
                  
                  
                  70
                  
                  
                  
                  69Alternative
      minimum tax credits
                  
                  
                  84
                  
                  
                  
                  85Tax
      credits from limited partnerships
                  
                  
                  300
                  
                  
                  
                  184Unrealized
      investment securities losses-net
                  
                  
                  2,429
                  
                  
                  
                  85Impairment
      loss on investment securities
                  
                  
                  177
                  
                  
                  
                  —Capital
      and net operating loss carry forwards
                  
                  
                  23
                  
                  
                  
                  —Total
                  
                  $
                  5,386
                  
                  
                  $
                  2,588Deferred
      Tax Liabilities:Loan
      fees and costs
                  
                  $
                  211
                  
                  
                  $
                  219Depreciation
                  
                  
                  271
                  
                  
                  
                  223Accretion
                  
                  
                  26
                  
                  
                  
                  72Mortgage
      servicing rights
                  
                  
                  4
                  
                  
                  
                  28Intangibles
                  
                  
                  452
                  
                  
                  
                  441Total
                  
                  $
                  964
                  
                  
                  $
                  983Net
      Deferred Tax Asset
                  
                  $
                  4,422
                  
                  
                  $
                  1,605





It is
anticipated that all deferred tax assets are to be realized and accordingly, no
valuation allowance has been provided.





The
Corporation and its subsidiary file a consolidated federal income tax
return.





NOTE
13  —   SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION





During
the years ended December 31, 2008, 2007 and 2006, cash payments for interest
expense and income taxes were as follows:





(Amounts
in thousands)


2008
                
                
                2007
                
                
                2006Interest
      paid on deposits and other borrowings
                
                $
                18,268
                
                
                $
                17,448
                
                
                $
                14,784Income
      taxes paid
                
                $
                1,598
                
                
                $
                1,752
                
                
                $
                1,380





The
Corporation transferred loans to foreclosed assets held-for-sale in amounts of
$342,000, $624,000 and $28,000 in 2008, 2007 and 2006,
respectively.


56


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued





Non-Cash
Investing and Financing Activities





On
November 1, 2007 First Keystone Corporation completed its acquisition of Pocono
Community Bank (See Note 2). A summary of the estimated fair value of the
non-cash assets acquired and the liabilities assumed at the date of acquisition
were as follows:





(Amounts
in thousands)





Assets
      Acquired:Investment
      securities
                  
                  $
                  13,122Loan,
      net of allowances for loan losses
                  
                  
                  104,752Premises
      and equipment-net
                  
                  
                  3,292Accrued
      interest receivable
                  
                  
                  596Cash
      surrender value of bank-owned life insurance
                  
                  
                  2,950Goodwill
      and other intangibles
                  
                  
                  19,838Other
      assets
                  
                  
                  1,065Total
      Assets Acquired
                  
                  $
                  145,615Liabilities
      Assumed:Deposits
                  
                  $
                  109,672Borrowings
                  
                  
                  5,908Other
      liabilities
                  
                  
                  413Total
      Liabilities Assumed
                  
                  $
                  115,993Net
      Non-Cash Assets Acquired
                  
                  $
                  29,622





The
Corporation issued 932,203 shares of common stock to the shareholders of Pocono
Community for a total of $15,996,000. The company paid $17,569,000 for the
acquisition less cash acquired from Pocono Community Bank in the amount of
$3,943,000 or a net cash expenditure of $13,626,000.





NOTE
14  —   EMPLOYEE BENEFIT PLANS AND DEFERRED
COMPENSATION AGREEMENTS





The
Corporation maintains a 401K Plan which has a combined tax qualified savings
feature and profit sharing feature for the benefit of its employees. Under the
savings feature, the Corporation matches 100% of the employee contribution up to
3% of compensation which amounted to $145,000, $111,000 and $102,000 in 2008,
2007 and 2006, respectively. Under the profit sharing feature, contributions, at
the discretion of the Board of Directors, are funded currently and amounted to
$353,000, $273,000 and $263,000 in 2008, 2007 and 2006,
respectively.





The Bank
also has non-qualified deferred compensation agreements with four of its
officers and three retired officers. These agreements are essentially unsecured
promises by the Bank to make monthly payments to the officers over a twenty year
period. Payments begin based upon specific criteria — generally, when the
officer retires. To account for the cost of payments yet to be made in the
future, the Bank recognizes an accrued liability in years prior to when payments
begin based on the present value of those future payments. The Bank’s accrued
liability for these deferred compensation agreements as of December 31, 2008 and
2007, was $1,173,000 and $1,071,000, respectively.  The related
expense for these plans amounted to $155,000, $125,000 and $108,000 in 2008,
2007 and 2006, respectively.





The Bank
entered into agreements to provide post-retirement benefits to a retired
employee in the form of life insurance payable to the employee’s estate upon
their death through endorsement split dollar life insurance arrangements. The
Corporation adopted the guidance in EITF 06-4 (See recent accounting
pronouncements in Note 1) effective January 1, 2007 to recognize the liabilities
for future benefits in the amount of $38,000.


57


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued





NOTE
15  —  COMMITMENTS AND
CONTINGENCIES





The
Corporation’s banking subsidiary currently leases four branch banking facilities
and one parcel of land, as well as two operation centers, under operating
leases. Rent expense for the years ended December 31, 2008, 2007 and 2006 was
$274,000, $216,000 and $162,000, respectively.  Minimum rental
payments required under these operating leases are: 2009 - $341,000, 2010 -
$338,000, 2011 - $339,000, 2012 - $285,000, 2013 - $272,000 and thereafter
$2,999,000.





The
banking subsidiary leases land and a bank building in Stroudsburg, Pennsylvania,
under a lease expiring in 2017. This lease has an operating lease commitment and
a capital lease component.  Minimum future rental payments as of
December 31, 2008 under this noncancelable operating lease component for land
are due as follows and are included in the amounts of operating lease payments
above.  2009 - $39,000, 2010 - $39,000, 2011 - $39,000, 2012 -
$39,000, 2013 - $39,000  and thereafter $151,000.





Minimum
future lease payments under the capital lease component for the bank building as
of December 31, 2008 for each of the next five years and in the aggregate
are:





Year Ending December 312009
                    
                    $
                    113,0002010
                    
                    
                    113,0002011
                    
                    
                    113,0002012
                    
                    
                    115,0002013
                    
                    
                    132,000Thereafter
                    
                    
                    515,000Total
      minimum lease payments
                    
                    
                    1,101,000Less
      amounts representing interest
                    
                    
                    344,000Present
      value of net minus lease payments
                    
                    $
                    757,000





In the
normal course of business, there are various pending legal actions and
proceedings that are not reflected in the consolidated financial statements.
Management does not believe the outcome of these actions and proceedings will
have a material effect on the consolidated financial position of the
Corporation.





The
banking subsidiary has entered into construction contracts to build a new bank
branch with outstanding commitments totaling $1,317,000 as of December 31,
2008.  In addition, the bank has a contract for a new core software
program suite for $1,387,000.





NOTE
16  —  RELATED PARTY
TRANSACTIONS





Certain
directors and executive officers of First Keystone Corporation and its
Subsidiary and companies in which they are principal owners (i.e., at least 10%)
were indebted to the Corporation at December 31, 2008, 2007 and 2006. These
loans were made on substantially the same terms and conditions, including
interest rates and collateral, as those prevailing at the time for comparable
transactions with unrelated parties. The loans do not involve more than the
normal risk of collectibility nor present other unfavorable
features.





A summary
of the activity on the related party loans, comprised of 9 directors and 3
executive officers and their related companies consists of the
following:





(Amounts
in thousands)


2008
                  
                  
                  2007
                  
                  
                  2006Balance
      at January 1
                  
                  $
                  3,650
                  
                  
                  $
                  939
                  
                  
                  $
                  1,221Additions
                  
                  
                  1,779
                  
                  
                  
                  4,074
                  
                  
                  
                  1,359Deductions
                  
                  
                  (1,887
                  )
                  
                  
                  (1,363
                  )
                  
                  
                  (1,641
                  )Balance
      at December 31
                  
                  $
                  3,542
                  
                  
                  $
                  3,650
                  
                  
                  $
                  939


58


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY


Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 – Continued





The above
loans represent funds drawn and outstanding at the date of the accompanying
consolidated financial statement. Commitments by the Bank to related parties on
lines of credit and letters of credit for 2008, 2007 and
2006,  presented an additional off-balance sheet risk to the extent of
undisbursed funds in the amounts of $2,889,000, $2,574,000 and $1,908,000,
respectively, on the above loans.





Deposits
from certain officers and directors and/or their affiliated companies held by
the Bank amounted to $6,603,000 and $7,950,000 at December 31, 2008 and 2007,
respectively.





NOTE
17  —  REGULATORY
MATTERS





Dividends
are paid by the Corporation to shareholders which are mainly provided by
dividends from the Bank. However, national banking laws place certain
restrictions on the amount of cash dividends allowed to be paid by the Bank to
the Corporation. Generally, the limitation provides that dividend payments may
not exceed the Bank's current year's retained income plus retained net income
for the preceding two years. During 2008, the Bank paid dividends to the
Corporation in the amount of $5,662,000 and the Bank’s net income for the year
ended December 31, 2008 was $7,855,000. During 2006 and 2007, the Bank paid
dividends to the Corporation in the amounts of $3,902,000 and $10,459,000
respectively, and the Bank’s net income for the years ended December 31, 2006
and 2007 was $5,927,000 and $5,817,000, respectively. The amount of dividends
paid in 2007 was utilized, in part, to fund the Pocono Community Bank
acquisition. Accordingly, in 2009, without prior regulatory approval, the Bank
may pay dividends to the Corporation after net income earned by the Bank in 2009
exceeds $424,000, less any dividends which may have been paid after $424,000 in
earnings is surpassed. Regulations also limit the amount of loans and advances
from the Bank to the Corporation to 10% of consolidated net assets.





The
Corporation is subject to various regulatory capital requirements administered
by the federal banking agencies. Failure to meet minimum capital requirements
can initiate certain mandatory — and possibly additional discretionary — actions
by regulators that, if undertaken, could have a direct material effect on the
Corporation’s financial statements. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Corporation must meet
specific capital guidelines that involve quantitative measures of the
Corporation’s assets, liabilities, and certain off-balance sheet items as
calculated under regulatory accounting practices. The Corporation’s capital
amounts and classification are also subject to qualitative judgements by the
regulators about components, risk weightings and other factors. Management
believes, as of December 31, 2008 and 2007, that the Corporation and the Bank
met all capital adequacy requirements to which they are subject.





Quantitative
measures established by regulation to ensure capital adequacy require the Bank
to maintain minimum amounts and ratios (set fourth in the table below) of Total
and Tier I Capital (as defined in the regulations) to Risk-Weighted Assets (as
defined), and of Tier I Capital (as defined) to Average Assets (as
defined).





As of
December 31, 2008, the most recent notification from the Office of the
Comptroller of the Currency categorized the Bank as Well Capitalized under the
regulatory framework for prompt corrective action. To be categorized as Well
Capitalized, the Bank must maintain minimum Total Risk-Based, Tier I
Risked-Based and Tier I Leverage Ratios as set forth in the table. There are no
conditions or events since the notification that management believes have
changed the Bank's category.





(Amounts in thousands)
                        
                        
                        
                        
                        
                        
                        
                        To Be WellCapitalized UnderFor Capital
                        
                        
                        Prompt CorrectiveActual
                        
                        
                        Adequacy Purposes
                        
                        
                        Action ProvisionsAmount
                        
                        
                        Ratio
                        
                        
                        Amount
                        
                        
                        Ratio
                        
                        
                        Amount
                        
                        
                        RatioAs
      of December 31, 2008:Total
      Capital(to
      Risk Weighted Assets)
                        
                        $
                        63,694
                        
                        
                        
                        13.03
                        %
                        
                        $
                        39,245
                        
                        
                        
                        8.00
                        %
                        
                        $
                        49,057
                        
                        
                        
                        10.00
                        %Tier
      I Capital(to
      Risk Weighted Assets)
                        
                        
                        58,499
                        
                        
                        
                        11.97
                        %
                        
                        
                        19,623
                        
                        
                        
                        4.00
                        %
                        
                        
                        29,434
                        
                        
                        
                        6.00
                        %Tier I Capital(to
      Average Assets)
                        
                        
                        58,499
                        
                        
                        
                        8.45
                        %
                        
                        
                        27,706
                        
                        
                        
                        4.00
                        %
                        
                        
                        34,633
                        
                        
                        
                        5.00
                        %


59


FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 - Continued
 
 (Amounts
      in thousands)
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            To
      Be WellCapitalized
      UnderFor
      Capital
                            
                            
                            Prompt
      CorrectiveActual
                            
                            
                            Adequacy Purposes
                            
                            
                            Action ProvisionsAmount
                            
                            
                            Ratio
                            
                            
                            Amount
                            
                            
                            Ratio
                            
                            
                            Amount
                            
                            
                            RatioAs
      of December 31, 2007:Total
      Capital(to
      Risk Weighted Assets)
                            
                            $
                            61,056
                            
                            
                            
                            14.28
                            %
                            
                            $
                            34,203
                            
                            
                            
                            8.00
                            %
                            
                            $
                            42,754
                            
                            
                            
                            10.00
                            %Tier
      I Capital(to
      Risk Weighted Assets)
                            
                            
                            56,010
                            
                            
                            
                            13.10
                            %
                            
                            
                            17,102
                            
                            
                            
                            4.00
                            %
                            
                            
                            25,652
                            
                            
                            
                            6.00
                            %Tier
      I Capital(to
      Average Assets)
                            
                            
                            56,010
                            
                            
                            
                            9.00
                            %
                            
                            
                            24,891
                            
                            
                            
                            4.00
                            %
                            
                            
                            31,113
                            
                            
                            
                            5.00
                            %
 
 The
Corporation’s capital ratios are not materially different from those of the
Bank.
 
 NOTE
18  —  FINANCIAL INSTRUMENTS WITH
OFF-BALANCE SHEET RISK AND CONCENTRATIONS OF CREDIT
RISK
 
 The
Corporation is a party to financial instruments with off-balance sheet risk in
the normal course of business to meet the financing needs of its customers.
These financial instruments include commitments to extend credit and standby
letters of credit. Those instruments involve, to varying degrees, elements of
credit and interest rate risk in excess of the amount recognized in the
consolidated balance sheets. The contract or notional amounts of those
instruments reflect the extent of involvement the Corporation has in particular
classes of financial instruments. The Corporation does not engage in trading
activities with respect to any of its financial instruments with off-balance
sheet risk.
 
 The
Corporation’s exposure to credit loss in the event of nonperformance by the
other party to the financial instrument for commitments to extend credit and
standby letters of credit is represented by the contractual notional amount of
those instruments.
 
 The
Corporation uses the same credit policies in making commitments and conditional
obligations as it does for on-balance sheet instruments.
 
 The
Corporation may require collateral or other security to support financial
instruments with off-balance sheet credit risk.
 
 The
contract or notional amounts at December 31, 2008 and 2007 were as
follows:
 
 (Amounts
in thousands)
 2008
                    
                    
                    2007Financial
      instruments whose contract amounts represent credit risk:Commitments
      to extend credit
                    
                    $
                    52,762
                    
                    
                    $
                    42,776Financial
      standby letters of credit
                    
                    $
                    904
                    
                    
                    $
                    1,744Performance
      standby letters of credit
                    
                    $
                    6,936
                    
                    
                    $
                    2,471
 
 Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract. Commitments generally
have fixed expiration dates or other termination clauses that may require
payment of a fee. Since many of the commitments are expected to expire without
being drawn upon, the total commitment amounts do not necessarily represent
future cash requirements. The Corporation evaluates each customer’s
creditworthiness on a case-by-case basis. The amount of collateral obtained, if
deemed necessary by the Corporation upon extension of credit, is based on
management’s credit evaluation of the counter-party. Collateral held varies but
may include accounts receivable, inventory, property, plant and equipment, and
income-producing commercial properties.
  60
 
 FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 - Continued
 
 Standby
letters of credit are conditional commitments issued by the Corporation to
guarantee payment to a third party when a customer either fails to repay an
obligation or fails to perform some non-financial obligation. The credit risk
involved in issuing letters of credit is essentially the same as that involved
in extending loan facilities to customers. The Corporation may hold collateral
to support standby letters of credit for which collateral is deemed
necessary.
 
 The
Corporation grants commercial, agricultural, real estate mortgage and consumer
loans to customers primarily in the counties of Columbia, Luzerne, Montour and
Monroe, Pennsylvania. The concentrations of credit by type of loan are set forth
in Note 5, “Loans”. It is management’s opinion that the loan portfolio was well
balanced and diversified at December 31, 2008, to the extent necessary to avoid
any significant concentration of credit risk. However, its debtors ability to
honor their contracts may be influenced by the region’s economy.
 
 NOTE
19  —  COMPREHENSIVE
INCOME
 
 The
components of other comprehensive income and related tax effects are as
follows:
 
 (Amounts
      in thousands)
                            
                            Years
      Ended December 31,2008
                            
                            
                            2007
                            
                            
                            2006Unrealized
      holding (losses) on available-for-sale investment securities arising
      during the period
                            
                            $
                            (7,023
                            )
                            
                            $
                            273
                            
                            
                            $
                            (1,220
                            )Less
      reclassification adjustment for net gains and losses realized in
      income
                            
                            
                            (171
                            )
                            
                            
                            426
                            
                            
                            
                            210Change
      in unrealized (losses) before tax effect
                            
                            $
                            (6,852
                            )
                            
                            $
                            (153
                            )
                            
                            $
                            (1,430
                            )Tax
      effects
                            
                            
                            2,347
                            
                            
                            
                            (113
                            )
                            
                            
                            (497
                            )Net
      change in unrealized (losses)
                            
                            $
                            (4,505
                            )
                            
                            $
                            (40
                            )
                            
                            $
                            (933
                            )
 
 NOTE
20  —  STOCKHOLDERS’
EQUITY
 
 On
November 1, 2007 First Keystone Corporation completed its acquisition of Pocono
Community Bank (See Note 2) and in connection therewith, issued 932,203 shares
of First Keystone common stock for a total of $15,996,000.
 
 On
October 24, 2006 the Board of Directors declared a 5% stock dividend payable to
shareholders of record
 November
14, 2006 and distributed December 5, 2006. A total of 215,991 shares were issued
as a result of this stock dividend, with a total value transferred from retained
earnings of $4,237,480, including cash in lieu of fractional
shares.
 
 The
Corporation also offers to its shareholders a Dividend Reinvestment and Stock
Purchase Plan. First Keystone Corporation is authorized to issue up to 200,000
shares of its common stock under the plan. The plan provides First Keystone
shareholders a convenient and economical way to purchase additional shares of
common stock by reinvesting dividends. A plan participant can elect full
dividend reinvestment or partial dividend reinvestment provided at least 25
shares are enrolled in the plan. In addition, plan participants may make
additional voluntary cash purchases of common stock under the plan of not less
than $100 per calendar quarter or more than $2,500 in any calendar
quarter.
 
 Shares of
First Keystone common stock are purchased for the plan either in the open market
by an independent broker on behalf of the plan, directly from First Keystone as
original issue shares, or through negotiated transactions. A combination of the
previous methods could also occur.
  61
  FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 - Continued
 
 Participation
in this plan by shareholders began in 2001. Shares transferred under this
dividend reinvestment and stock purchase plan were as follows:
 
 Year
                        
                        Number
      of Shares2001
                        
                        
                        3,2602002
                        
                        
                        7,7472003
                        
                        
                        8,0002004
                        
                        
                        13,9322005
                        
                        
                        21,4912006
                        
                        
                        22,9642007
                        
                        
                        25,9002008
                        
                        
                        34,389
 
 NOTE
21  —  STOCK COMPENSATION
PLAN
 
 On
February 10, 1998, the Board of Directors adopted a stock option incentive plan
and initially reserved 100,000 shares of common stock for issuance under the
plan for certain employees of the Bank. After adjustments for the effects of
stock dividends, options exercised and options forfeited there remains 68,104
options for possible issuance.  Under the Plan, options are granted at
fair market value and the time period during which any option granted may be
exercised may not commence before six months or continue beyond the expiration
of ten years after the option is awarded.  Upon exercise of the stock
options, shares of the Corporation’s stock are issued from Treasury
Stock.
 
 On
December 27, 2007, the Board of Directors issued 6,250 stock
options.
 
 The fair
value of stock options issued to employees is measured on the date of the grant
and is recognized as compensation expense over the requisite service
period.  Expected volatility and dividend yield are based on
historical stock prices and dividend amounts over past time periods equal in
length to the life of the options.  The risk-free interest rate is
determined using the U.S. Treasury yield curve in effect at the date of the
grant.  The expected life of the options is calculated using the
average term of the vesting period and the maximum term.
 
 Stock
based compensation expense was $18,000 and $1,000 for the years ended December
31, 2008 and 2007, respectively, attributable to stock options granted in
2007.  Stock based compensation expense was $8,000 for the year
ended  December 31, 2006 attributable to stock options granted in
2005.
 
 The fair
value of each option grant is estimated on the date of grant using the Binomial
Option Pricing Model derived from the Black-Scholes Option Pricing Model with
the following weighted-average assumptions used for options granted in 2007 and
2005, respectively: dividend yield of 5.25% and 4.05%; expected volatility of
26.17% and 23.04%; risk-free interest rate of 3.64% and 4.39%; and an expected
life of 5.25 years and 10 years.
  62
  FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 - Continued
 
 Information
about stock options outstanding at December 31, 2008, is summarized as
follows:
 
 2008
                                                      
                                                      
                                                      2007
                                                      
                                                      
                                                      2006Weighted
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      Weighted
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      WeightedAverage
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      Average
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      AverageStock
                                                      
                                                      
                                                      Exercise
                                                      
                                                      
                                                      Stock
                                                      
                                                      
                                                      Exercise
                                                      
                                                      
                                                      Stock
                                                      
                                                      
                                                      ExerciseOptions
                                                      
                                                      
                                                      Price
                                                      
                                                      
                                                      Options
                                                      
                                                      
                                                      Price
                                                      
                                                      
                                                      Options
                                                      
                                                      
                                                      PriceBalance
      at January 1
                                                      
                                                      
                                                      54,562
                                                      
                                                      
                                                      $
                                                      17.65
                                                      
                                                      
                                                      
                                                      51,383
                                                      
                                                      
                                                      $
                                                      17.55
                                                      
                                                      
                                                      
                                                      60,619
                                                      
                                                      
                                                      $
                                                      18.61Granted
                                                      
                                                      
                                                      —
                                                      
                                                      
                                                      
                                                      —
                                                      
                                                      
                                                      
                                                      6,250
                                                      
                                                      
                                                      
                                                      16.75
                                                      
                                                      
                                                      
                                                      —
                                                      
                                                      
                                                      
                                                      —Granted
      due to stock dividend
                                                      
                                                      
                                                      —
                                                      
                                                      
                                                      
                                                      —
                                                      
                                                      
                                                      
                                                      —
                                                      
                                                      
                                                      
                                                      —
                                                      
                                                      
                                                      
                                                      2,404
                                                      
                                                      
                                                      
                                                      17.56Exercised
                                                      
                                                      
                                                      (50
                                                      )
                                                      
                                                      
                                                      15.88
                                                      
                                                      
                                                      
                                                      —
                                                      
                                                      
                                                      
                                                      —
                                                      
                                                      
                                                      
                                                      (4,415
                                                      )
                                                      
                                                      
                                                      16.23Forfeited
                                                      
                                                      
                                                      (12,817
                                                      )
                                                      
                                                      
                                                      19.80
                                                      
                                                      
                                                      
                                                      (3,071
                                                      )
                                                      
                                                      
                                                      15.95
                                                      
                                                      
                                                      
                                                      (7,225
                                                      )
                                                      
                                                      
                                                      21.33Balance
      at December 31
                                                      
                                                      
                                                      41,695
                                                      
                                                      
                                                      
                                                      16.86
                                                      
                                                      
                                                      
                                                      54,562
                                                      
                                                      
                                                      
                                                      17.55
                                                      
                                                      
                                                      
                                                      51,383
                                                      
                                                      
                                                      
                                                      17.55Exercisable
      at December 31
                                                      
                                                      
                                                      41,695
                                                      
                                                      
                                                      $
                                                      16.86
                                                      
                                                      
                                                      
                                                      48,312
                                                      
                                                      
                                                      $
                                                      17.65
                                                      
                                                      
                                                      
                                                      51,383
                                                      
                                                      
                                                      $
                                                      17.55Weighted
      average fair value of options granted during the year
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      $
                                                      2.98
 
 Under the
terms of the stock option incentive plan, the stock options including amendments
as to price and terms were adjusted for the stock dividend in 2006.
 
 Exercise
prices of options outstanding as of December 31, 2008, ranged from $10.28 to
$21.11 per share. The weighted average remaining contracted life is
approximately 4.05 years.
 
 The
41,695 options outstanding as December 31, 2008 have an intrinsic value, which
is the amount that the value of the underlying stock exceeds the exercise price
of the options of $21,000.  The total intrinsic value of the options
exercised during the years ended December 31, 2008, 2007 and 2006 was $0, $0 and
$10,000, respectively.  Cash received from stock options exercised for
the years ended December 31, 2008, 2007 and 2006 was $1,000, $0 and $72,000,
respectively.
 
 The
following table summarizes information concerning the 1998 Employee Stock Option
Plan at December 31, 2008.
 
 Options
      Outstanding
                                            
                                            
                                            Options
      ExercisableWeighted
                                            
                                            
                                            Weighted
                                            
                                            
                                            
                                            
                                            
                                            WeightedAverage
                                            
                                            
                                            Average
                                            
                                            
                                            
                                            
                                            
                                            AverageNumber
                                            
                                            
                                            Remaining
                                            
                                            
                                            Exercise
                                            
                                            
                                            Number
                                            
                                            
                                            ExerciseYear
                                            
                                            Outstanding*
                                            
                                            
                                            Contractual
      Life
                                            
                                            
                                            Price
                                            
                                            
                                            Exercisable
                                            
                                            
                                            Price1999
                                            
                                            
                                            9,579
                                            
                                            
                                            
                                            .75
                                            
                                            
                                            
                                            15.88
                                            
                                            
                                            
                                            9,579
                                            
                                            
                                            
                                            15.882000
                                            
                                            
                                            4,950
                                            
                                            
                                            
                                            1.75
                                            
                                            
                                            
                                            10.28
                                            
                                            
                                            
                                            4,950
                                            
                                            
                                            
                                            10.282002
                                            
                                            
                                            7,787
                                            
                                            
                                            
                                            3.75
                                            
                                            
                                            
                                            15.08
                                            
                                            
                                            
                                            7,787
                                            
                                            
                                            
                                            15.082003
                                            
                                            
                                            10,231
                                            
                                            
                                            
                                            4.75
                                            
                                            
                                            
                                            21.11
                                            
                                            
                                            
                                            10,231
                                            
                                            
                                            
                                            21.112005
                                            
                                            
                                            3,148
                                            
                                            
                                            
                                            6.75
                                            
                                            
                                            
                                            20.95
                                            
                                            
                                            
                                            3,148
                                            
                                            
                                            
                                            20.952007
                                            
                                            
                                            6,000
                                            
                                            
                                            
                                            9.00
                                            
                                            
                                            
                                            16.75
                                            
                                            
                                            
                                            6,000
                                            
                                            
                                            
                                            16.7541,695
                                            
                                            
                                            
                                            4.05
                                            
                                            
                                            
                                            16.86
                                            
                                            
                                            
                                            41,695
                                            
                                            
                                            
                                            16.86
 
 *As
adjusted for stock dividend noted above.
  63
  FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 - Continued
 
 NOTE
22  —   FAIR VALUES OF FINANCIAL
INSTRUMENTS
 
 Statement
of Financial Accounting Standards (SFAS) 107, “Disclosures about Fair Value of
Financial Instruments”, requires disclosure of fair value information about
financial instruments, whether or not required to be recognized in the
consolidated balance sheets, for which it is practicable to estimate such fair
value. In cases where quoted market prices are not available, fair values are
based on estimates using present value or other valuation techniques. These
techniques are significantly affected by the assumptions used, including the
discount rate and estimates of future cash flows. Fair value estimates derived
through these techniques cannot be substantiated by comparison to independent
markets and, in many cases, could not be realized in immediate settlement of the
instrument. SFAS 107 excludes certain financial instruments and all nonfinancial
instruments from its disclosure requirements. Accordingly, the aggregate fair
value amounts presented do not represent the underlying value of the
Corporation.
 
 The
following methods and assumptions were used by the Corporation in estimating its
fair value disclosures for financial instruments:
 
 Cash
and Due From Banks, Short-Term Investments, Accrued Interest Receivable and
Accrued Interest Payable
 
 The fair
values are equal to the current carrying values.
 
 Investment
Securities
 
 Fair
values have been individually determined based on currently quoted market
prices. If a quoted market price is not available, fair value is estimated using
quoted market prices for similar securities.
 
 Loans
 
 Fair
values are estimated for categories of loans with similar financial
characteristics. Loans were segregated by type such as commercial, tax-exempt,
real estate mortgages and consumer. For estimation purposes each loan category
was further segmented into fixed and adjustable rate interest terms and also
into performing and non-performing classifications.
 
 The fair
value of each category of performing loans is calculated by discounting 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.
 
 Fair
value for non-performing loans is based on management’s estimate of future cash
flows discounted using a rate commensurate with the risk associated with the
estimated future cash flows. The assumptions used by management are judgmentally
determined using specific borrower information.
 
 Cash
Surrender Value of Bank Owned Life Insurance
 
 Fair
value is equal to the cash surrender value of life insurance
policies.
 
 Deposits
 
 Under
SFAS 107, the fair value of deposits with no stated maturity, such as Demand
Deposits, Savings Accounts and Money Market Accounts is equal to the amount
payable on demand at December 31, 2008 and 2007.
 
 Fair
values for fixed-rate certificates of deposit are estimated using a discounted
cash flow calculation that applies interest rates currently being offered on
similar term borrowings, to a schedule of aggregated expected monthly maturities
on time deposits.
  64
  FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 - Continued
 
 Short-Term
and Long-Term Borrowings
 
 The fair
values of short-term and long-term borrowings are estimated using discounted
cash flow analyses based on the Corporation's incremental borrowing rate for
similar instruments.
 
 Commitments
to Extend Credit and Standby Letters of Credit
 
 Management
estimates that there are no material differences between the notional amount and
the estimated fair value of those off-balance sheet items since they are
primarily composed of unfunded loan commitments which are generally priced at
market at the time of funding.
 
 At
December 31, 2008 and 2007, the carrying values and estimated fair values of
financial instruments of the Corporation are presented in the table
below:
 
 (Amounts
      in thousands)
                      
                      2008
                      
                      
                      2007Carrying
                      
                      
                      Estimated
                      
                      
                      Carrying
                      
                      
                      EstimatedAmount
                      
                      
                      Fair
      Value
                      
                      
                      Amount
                      
                      
                      Fair
      ValueFINANCIAL
      ASSETS:Cash
      and due from banks
                      
                      $
                      9,945
                      
                      
                      $
                      9,945
                      
                      
                      $
                      9,886
                      
                      
                      $
                      9,886Short-term
      investments
                      
                      
                      6
                      
                      
                      
                      6
                      
                      
                      
                      89
                      
                      
                      
                      89Investment
      securities - available for sale
                      
                      
                      240,175
                      
                      
                      
                      240,175
                      
                      
                      
                      241,521
                      
                      
                      
                      241,521Investment
      securities - held to maturity
                      
                      
                      2,990
                      
                      
                      
                      2,906
                      
                      
                      
                      4,539
                      
                      
                      
                      4,553Net
      loans
                      
                      
                      403,172
                      
                      
                      
                      413,226
                      
                      
                      
                      371,556
                      
                      
                      
                      364,380Accrued
      interest receivable
                      
                      
                      4,228
                      
                      
                      
                      4,228
                      
                      
                      
                      3,241
                      
                      
                      
                      3,241Cash
      surrender value of life insurance
                      
                      
                      17,157
                      
                      
                      
                      17,157
                      
                      
                      
                      16,450
                      
                      
                      
                      16,450FINANCIAL
      LIABILITIES:Deposits
                      
                      
                      504,633
                      
                      
                      
                      499,922
                      
                      
                      
                      493,041
                      
                      
                      
                      478,109Short-term
      borrowings
                      
                      
                      55,332
                      
                      
                      
                      55,332
                      
                      
                      
                      47,349
                      
                      
                      
                      47,349Long-term
      borrowings
                      
                      
                      82,062
                      
                      
                      
                      87,555
                      
                      
                      
                      66,175
                      
                      
                      
                      68,736Accrued
      interest and other expenses
                      
                      
                      3,488
                      
                      
                      
                      3,488
                      
                      
                      
                      3,454
                      
                      
                      
                      3,454OFF-BALANCE
      SHEET FINANCIAL INSTRUMENTS:Commitments
      to extend credit
                      
                      
                      
                      
                      
                      
                      52,762
                      
                      
                      
                      
                      
                      
                      
                      42,776Financial
      standby letters of credit
                      
                      
                      
                      
                      
                      
                      904
                      
                      
                      
                      
                      
                      
                      
                      1,744Performance
      standby letters of credit
                      
                      
                      
                      
                      
                      
                      6,936
                      
                      
                      
                      
                      
                      
                      
                      2,471
  65
 
 FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 - Continued
 
 NOTE
23  —  PARENT COMPANY FINANCIAL
INFORMATION
 
 Condensed
financial information for First Keystone Corporation (parent company only) was
as follows:
 
 BALANCE
      SHEETS(Amounts
      in thousands)
                                    
                                    December
      312008
                                    
                                    
                                    2007ASSETSCash
      in subsidiary bank
                                    
                                    $
                                    1,380
                                    
                                    
                                    $
                                    316Investment
      in subsidiary bank
                                    
                                    
                                    74,804
                                    
                                    
                                    
                                    76,962Investment
      in other equity securities
                                    
                                    
                                    1,911
                                    
                                    
                                    
                                    2,917Prepayments
      and other assets
                                    
                                    
                                    650
                                    
                                    
                                    
                                    330TOTAL
      ASSETS
                                    
                                    $
                                    78,745
                                    
                                    
                                    $
                                    80,525LIABILITIESAccrued
      expenses and other liabilities
                                    
                                    $
                                    —
                                    
                                    
                                    $
                                    102Advance
      from subsidiary bank
                                    
                                    
                                    9,598
                                    
                                    
                                    
                                    9,499TOTAL
      LIABILITIES
                                    
                                    $
                                    9,598
                                    
                                    
                                    $
                                    9,601STOCKHOLDERS’
      EQUITYPreferred
      stock
                                    
                                    $
                                    —
                                    
                                    
                                    $
                                    —Common
      stock
                                    
                                    
                                    11,375
                                    
                                    
                                    
                                    11,375Surplus
                                    
                                    
                                    30,269
                                    
                                    
                                    
                                    30,252Retained
      earnings
                                    
                                    
                                    38,414
                                    
                                    
                                    
                                    35,705Accumulated
      other comprehensive income (loss)
                                    
                                    
                                    (4,671
                                    )
                                    
                                    
                                    (166
                                    )Treasury
      stock, at cost
                                    
                                    
                                    (6,240
                                    )
                                    
                                    
                                    (6,242
                                    )TOTAL
      STOCKHOLDERS’ EQUITY
                                    
                                    $
                                    69,147
                                    
                                    
                                    $
                                    70,924TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY
                                    
                                    $
                                    78,745
                                    
                                    
                                    $
                                    80,525
 
 STATEMENTS
      OF INCOME(Amounts
      in thousands)
                                                
                                                Year
      Ended December 312008
                                                
                                                
                                                2007
                                                
                                                
                                                2006INCOMEDividends
      from Subsidiary Bank
                                                
                                                $
                                                5,662
                                                
                                                
                                                $
                                                10,459
                                                
                                                
                                                $
                                                3,902Dividends
      - other
                                                
                                                
                                                100
                                                
                                                
                                                
                                                107
                                                
                                                
                                                
                                                89Securities
      gains (losses)
                                                
                                                
                                                (542
                                                )
                                                
                                                
                                                420
                                                
                                                
                                                
                                                362Interest
                                                
                                                
                                                11
                                                
                                                
                                                
                                                32
                                                
                                                
                                                
                                                33TOTAL
      INCOME
                                                
                                                $
                                                5,231
                                                
                                                
                                                $
                                                11,018
                                                
                                                
                                                $
                                                4,386Operating
      Expenses
                                                
                                                
                                                86
                                                
                                                
                                                
                                                89
                                                
                                                
                                                
                                                84Income
      Before Taxes and Equity inUndistributed
      Net Income of Subsidiary
                                                
                                                $
                                                5,145
                                                
                                                
                                                $
                                                10,929
                                                
                                                
                                                $
                                                4,302Income
      tax expense
                                                
                                                
                                                (213
                                                )
                                                
                                                
                                                160
                                                
                                                
                                                
                                                137Income
      Before Equity in Undistributed NetIncome
      of Subsidiary
                                                
                                                $
                                                5,358
                                                
                                                
                                                $
                                                10,769
                                                
                                                
                                                $
                                                4,165Equity
      in (excess of) Undistributed Net Income of Subsidiary
                                                
                                                
                                                2,193
                                                
                                                
                                                
                                                (4,642
                                                )
                                                
                                                
                                                2,025NET
      INCOME
                                                
                                                $
                                                7,551
                                                
                                                
                                                $
                                                6,127
                                                
                                                
                                                $
                                                6,190
  66
  FIRST
KEYSTONE CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements for the Years Ended December 31, 2008, 2007
and 2006 - Continued
 
 STATEMENTS
      OF CASH FLOWS(Amounts
      in thousands)
                                                                        
                                                                        Year
      Ended December 312008
                                                                        
                                                                        
                                                                        2007
                                                                        
                                                                        
                                                                        2006OPERATING
      ACTIVITIESNet
      income
                                                                        
                                                                        $
                                                                        7,551
                                                                        
                                                                        
                                                                        $
                                                                        6,127
                                                                        
                                                                        
                                                                        $
                                                                        6,190Adjustments
      to reconcile net income to net cashprovided
      by operating activities:Securities
      (gains) losses
                                                                        
                                                                        
                                                                        105
                                                                        
                                                                        
                                                                        
                                                                        (420
                                                                        )
                                                                        
                                                                        
                                                                        (362
                                                                        )Deferred
      income tax benefit
                                                                        
                                                                        
                                                                        (196
                                                                        )
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        —Impairment
      loss on investment securities
                                                                        
                                                                        
                                                                        437
                                                                        
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        —Equity
      in (excess of) undistributed net income of subsidiary
                                                                        
                                                                        
                                                                        (2,193
                                                                        )
                                                                        
                                                                        
                                                                        4,642
                                                                        
                                                                        
                                                                        
                                                                        (2,025
                                                                        )(Increase)
      decrease in prepaid expenses and other assets
                                                                        
                                                                        
                                                                        (18
                                                                        )
                                                                        
                                                                        
                                                                        (56
                                                                        )
                                                                        
                                                                        
                                                                        (150
                                                                        )Increase
      (decrease) in advances payable to subsidiary bank -net
      operating
                                                                        
                                                                        
                                                                        117
                                                                        
                                                                        
                                                                        
                                                                        71
                                                                        
                                                                        
                                                                        
                                                                        102Increase
      (decrease) in accrued expensesand other
      liabilities
                                                                        
                                                                        
                                                                        (102
                                                                        )
                                                                        
                                                                        
                                                                        38
                                                                        
                                                                        
                                                                        
                                                                        (30
                                                                        )NET
      CASH PROVIDED BY OPERATING ACTIVITIES
                                                                        
                                                                        $
                                                                        5,701
                                                                        
                                                                        
                                                                        $
                                                                        10,402
                                                                        
                                                                        
                                                                        $
                                                                        3,725INVESTING
      ACTIVITIESPurchase
      of equity securities
                                                                        
                                                                        $
                                                                        —
                                                                        
                                                                        
                                                                        $
                                                                        (765
                                                                        )
                                                                        
                                                                        $
                                                                        (1,403
                                                                        )Proceeds
      from sale of equity securities
                                                                        
                                                                        
                                                                        204
                                                                        
                                                                        
                                                                        
                                                                        1,052
                                                                        
                                                                        
                                                                        
                                                                        859Purchase
      of bank
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        (16,539
                                                                        )
                                                                        
                                                                        
                                                                        —NET
      CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES
                                                                        
                                                                        $
                                                                        204
                                                                        
                                                                        
                                                                        $
                                                                        (16,252
                                                                        )
                                                                        
                                                                        $
                                                                        (544
                                                                        )FINANCING
      ACTIVITIESProceeds
      from sale of treasury stock
                                                                        
                                                                        $
                                                                        1
                                                                        
                                                                        
                                                                        $
                                                                        —
                                                                        
                                                                        
                                                                        $
                                                                        71Acquisition
      of treasury stock
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        (332
                                                                        )
                                                                        
                                                                        
                                                                        (1,514
                                                                        )Cash
      dividends paid
                                                                        
                                                                        
                                                                        (4,842
                                                                        )
                                                                        
                                                                        
                                                                        (4,179
                                                                        )
                                                                        
                                                                        
                                                                        (3,874
                                                                        )Dividends
      paid in lieu of fractional shares
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        (4
                                                                        )Advances
      from subsidiary bank
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        9,029
                                                                        
                                                                        
                                                                        
                                                                        —NET
      CASH PROVIDED BY (USED IN)FINANCING
    ACTIVITIES
                                                                        
                                                                        $
                                                                        (4,841
                                                                        )
                                                                        
                                                                        $
                                                                        4,518
                                                                        
                                                                        
                                                                        $
                                                                        (5,321
                                                                        )INCREASE
      (DECREASE) IN CASH AND CASH EQUIVALENTS
                                                                        
                                                                        $
                                                                        1,064
                                                                        
                                                                        
                                                                        $
                                                                        (1,332
                                                                        )
                                                                        
                                                                        $
                                                                        (2,140
                                                                        )CASH
      AND CASH EQUIVALENTS AT BEGINNING OF YEAR
                                                                        
                                                                        
                                                                        316
                                                                        
                                                                        
                                                                        
                                                                        1,648
                                                                        
                                                                        
                                                                        
                                                                        3,788CASH
      AND CASH EQUIVALENTS AT END OF YEAR
                                                                        
                                                                        $
                                                                        1,380
                                                                        
                                                                        
                                                                        $
                                                                        316
                                                                        
                                                                        
                                                                        $
                                                                        1,648
  67
 
 REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM
 
 BOARD OF
DIRECTORS AND STOCKHOLDERS OF FIRST KEYSTONE CORPORATION
 
 We have
audited First Keystone Corporation’s internal control over financial reporting
as of December 31, 2008, based on criteria established in Internal Control — Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).  The Corporation’s management is
responsible for maintaining effective internal control over financial reporting
and for its assessment of the effectiveness of internal control over financial
reporting included in the accompanying Report of Management on Internal Control
over Financial Reporting.  Our responsibility is to express an opinion
on of the Corporation’s internal control over financial reporting based on our
audit.
 
 We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects.  Our audit of internal control over financial
reporting included obtaining an understanding of internal control over financial
reporting, assessing the risk that a material weakness exists and testing and
evaluating the design and operating effectiveness of internal control based on
the assessed risk. Our audit also included performing such other procedures as
we considered necessary in the circumstances.  We believe that our
audit provides a reasonable basis for our opinion.
 
 A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with accounting principles generally accepted in the United States of
America.  A company’s internal control over financial reporting
includes those policies and procedures that (1) pertain to the maintenance of
records that, in reasonable detail, accurately and fairly reflect the
transactions and dispositions of the assets of the company; (2) provide
reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with accounting principles
generally accepted in the United States of America and that receipts and
expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the company’s assets that could have a
material effect on the financial statements.
 
 Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.
 
 In our
opinion, First Keystone Corporation maintained, in all material respects,
effective internal control over financial reporting as of December 31, 2008,
based on criteria established in Internal Control — Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).
 
 We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of First
Keystone Corporation and Subsidiary as of December 31, 2008 and 2007 and the
related consolidated statements of income, changes in stockholders’ equity and
cash flows for each of the years in the three-year period ended December 31,
2008 and our report dated March 9, 2009 expressed an unqualified opinion on
those consolidated financial statements.
 
 J. H. Williams & Co.,
    LLPJ.
      H. Williams & Co.,
LLP
 Kingston,
Pennsylvania
 March 9,
2009
  68
 
 ITEM
9.        CHANGES IN AND DISAGREEMENTS
WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
 
 Not
Applicable.
 
 ITEM
9A.     CONTROLS AND PROCEDURES
 
 Evaluation
of Disclosure Controls and Procedures
 
 The
Management of First Keystone Corporation (the “Corporation”), with the
participation of the Chief Executive Officer and Chief Financial Officer,
conducted an evaluation of the effectiveness of our disclosure controls and
procedures, pursuant to Securities Exchange Act Rules 13a-15, as amended, as of
December 31, 2008. Based upon such evaluation, the Corporation’s Chief Executive
Officer and Chief Financial Officer have concluded that, as of the end of such
period, the Corporation’s disclosure controls and procedures are effective in
timely alerting them to material information relating to the Corporation
required to be included in our periodic SEC filings.
 
 Management’s
Report on Internal Control Over Financial Reporting
 
 The
management of First Keystone Corporation is responsible for establishing and
maintaining adequate internal control over financial reporting.  The
Corporation’s internal control system was designed to provide reasonable
assurance to the Corporation’s management and Board of Directors regarding the
preparation and fair presentation of published financial
statements.
 
 The
Corporation’s internal control over financial reporting are supported by written
policies that pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect transactions and dispositions of assets; provide
reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with accounting principles
generally accepted in the United States of America, and that receipt and
expenditures of the Corporation are being made only in accordance with
authorization of the Corporation’s management and Board of Directors; and
provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use or disposition of the Corporation’s assets that
could have a material effect on the consolidated financial
statements.
 
 All
internal control systems, no matter how well designed, have inherent
limitations.  Therefore, even those systems determined to be effective
can provide only reasonable assurance with respect to financial statement
preparation and presentation.  Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
 
 The
management of First Keystone Corporation assessed the effectiveness of the
Corporation’s internal control over financial reporting as of December 31,
2008.  In making this assessment, we used the criteria set forth by
the Committee of Sponsoring Organizations of the Treadway Commission (COSO)
in  Internal Control
— Integrated Framework.  Based on our assessment we believe
that, as of December 31, 2008, the Corporation’s internal control over financial
reporting is effective based on those criteria.
 
 First
Keystone Corporation’s independent registered public accounting firm that
audited the consolidated financial statements has issued an audit report on our
assessment of, and the effective operation of, the Corporation’s internal
control over financial reporting as of December 31, 2008.  This report
appears on page 68.
 
 Changes
in Internal Controls
 
 The
Corporation made no changes in its internal controls or in other factors that
has materially affected, or is reasonably likely to materially affect these
controls subsequent to the date of the evaluation of the controls by the Chief
Executive and Chief Financial Officers.
 
 ITEM
9B.     OTHER INFORMATION
 
 Not
Applicable.
  69
  PART
III
 
 ITEM
10.      DIRECTORS, EXECUTIVE OFFICERS AND
CORPORATE GOVERNANCE
 
 The
information under the captions “Information As To Directors and Nominees,”
“Principal Officers of the Bank and the Corporation” and “Committees of the
Board of Directors” are incorporated here by reference from First Keystone
Corporation's proxy statement for its 2009 annual meeting of shareholders
scheduled for May 5, 2009.  The information under the caption “Section
16(A) Beneficial Ownership Reporting Compliance” and “Code of Ethics” are as
follows:
 
 SECTION
16(A) BENEFICIAL OWNERSHIP
 REPORTING
COMPLIANCE
 
 Section
16(a) of the Securities Exchange Act of 1934 requires the Corporation’s
directors, executive officers and shareholders who own more than 10% of the
Corporation’s outstanding equity stock to file initial reports of ownership and
reports of changes in ownership of common stock and other equity securities of
the Corporation with the Securities and Exchange Commission.  Based
solely on its review of copies of Section 16(a) forms received by it, or written
representations from reporting persons that no Form 5's were required for those
persons, the corporation believes that during the period January 1, 2008 through
December 31, 2008, its officers, directors and reporting shareholders were in
compliance with all filing requirements applicable to them.
 
 CODE OF
ETHICS
 
 The
Corporation has adopted a Directors and Senior Management Code of Ethical
Conduct, which applies to all members of the Board of Directors and to senior
officers of the Corporation.  It can be found on the Investor
Relations section of our website at
www.firstkeystonecorporation.com.
 
 ITEM 11.      EXECUTIVE
COMPENSATION
 
 The
information under the captions “Executive Compensation” (pages 21 through 30),
“Compensation Discussion and Analysis (CD&A),” Compensation Committee
Interlocks and Insider Participation,” and Compensation Committee Report” are
incorporated here by reference from First Keystone Corporation's proxy statement
for its 2009 annual meeting of shareholders scheduled for May 5,
2009.
 
 ITEM 12.      SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
SHAREHOLDER MATTERS
 
 The
information under the caption “Share Ownership” and “Equity Compensation Plan
Information” are incorporated here by reference from First Keystone
Corporation's proxy statement for its 2009 annual meeting of shareholders
scheduled for May 5, 2009.
 
 ITEM 13.      CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
 
 The
information under the captions “Related Person Transactions” and “Governance Of
The Company” are incorporated here by reference from First Keystone
Corporation's proxy statement for its 2009 annual meeting of shareholders
scheduled for
 May 5,
2009.
 
 ITEM
14.      PRINCIPAL ACCOUNTANT FEES AND
SERVICES
 
 The
information under the caption “Report of the Audit Committee” is incorporated
here by reference from First Keystone Corporation’s proxy statement for its 2009
annual meeting of shareholders scheduled for May 5, 2009.
  70
  PART
IV
 
 ITEM
15.      EXHIBITS AND FINANCIAL STATEMENT
SCHEDULES
 
 (a)           1.   Financial
Statements
 
 The
following consolidated financial statements are included in Part II, Item 8, of
this Report:
 
 First
Keystone Corporation and Subsidiary.
 
 Report
      of Independent Registered Public Accounting Firm
                    
                    
                    30Consolidated
      Balance Sheets
                    
                    
                    31Consolidated
      Statements of Income
                    
                    
                    32Consolidated
      Statements of Stockholders’ Equity
                    
                    
                    33Consolidated
      Statements of Cash Flows
                    
                    
                    34Notes
      to Consolidated Financial Statements
                    
                    
                    35Report
      of Independent Registered Public Accounting Firm
                    
                    
                    68
 
 2.   Financial Statement
Schedules
 
 Financial
statements schedules are omitted because the required information is either not
applicable, not required,  or is shown in the financial statements or
in their notes.
 
 3.  Exhibits
 
 Exhibits
required by Item 601 of Regulation S:
 
 Exhibit Number Referred to
                  Item 601 of Regulation S-K
                
                Description of Exhibit3i
                
                Articles
      of Incorporation, as amended (Incorporated by reference to Exhibit 3(I) to
      the Registrant's Report on Form 10-Q for the quarter ended March 31,
      2006).3ii
                
                By-Laws,
      as amended (Incorporated by reference to Exhibit 3(ii) to the Registrant's
      Report on Form 8-K dated February 25, 2009).10.1
                
                Supplemental
      Employee Retirement Plan (Incorporated by reference to Exhibit 10 to
      Registrant's Annual Report on Form 10-Q for the quarter ended September
      31, 2005).10.2
                
                Management
      Incentive Compensation Plan (Incorporated by reference to Exhibit 10 to
      Registrant's Report on Form 10-Q for the quarter ended September 30,
      2006).10.3
                
                Profit
      Sharing Plan (Incorporated by reference to Exhibit 10 to Registrant's
      Report on Form 10-Q for the quarter ended September 30,
    2006).10.4
                
                First
      Keystone Corporation 1998 Stock Incentive Plan (Incorporated by reference
      to Exhibit 10 to Registrant's Report on Form 10-Q for the quarter ended
      September 30, 2006).
  71
 
 Exhibit
      Number Referred to
                  Item 601 of Regulation S-K
                
                Description of Exhibit
      (Continued)10.5
                
                Employment
      Agreement between First Keystone Corporation, First Keystone National Bank
      and John G. Gerlach dated May 10, 2007 (Incorporated by reference to Annex
      B to the Proxy Statement/Prospectus on the Registrant’s Registration
      Statement on Form S-4, as amended (No. 333-145658)).10.6
                
                Consulting
      Agreement between Keystone Corporation, First Keystone National Bank and
      John G. Gerlach dated May 10, 2007 (Incorporated by reference to Annex C
      to the Proxy Statement/Prospectus on the Registrant’s Registration
      Statement on Form S-4, as amended (No. 333-145658)).10.7
                
                Form
      of Non-Competition and Non-Solicitation Agreement by and between First
      Keystone Corporation and the Pocono Community Bank directors (Incorporated
      by reference to Annex F to the Proxy Statement/Prospectus on the
      Registrant’s Registration Statement on Form S-4, as amended (No.
      333-145658)).14
                
                Code
      of Ethics (Incorporated by reference to Exhibit 14 to Registrant’s Report
      on Form 8-K dated January 9, 2007).21
                
                List
      of Subsidiaries of the Corporation.23
                
                Consent
      of Independent Auditors.31.1
                
                Rule
      13a-14(a)/15d-14(a) Certification of Chief Executive
    Officer.31.2
                
                Rule
      13a-14(a)/15d-14(a) Certification of Chief Financial
    Officer.32.1
                
                Section
      1350 Certification of Chief Executive Officer.32.2
                
                Section
      1350 Certification of Chief Financial
Officer.
  72
 
 SIGNATURES
 
 Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act
of 1934, the Registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
 
 FIRST
      KEYSTONE CORPORATION/s/ J. Gerald BazewiczJ.
      Gerald BazewiczPresident/Chief
      Executive OfficerDate:
                      March
      10, 2009
 
 Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the Registrant and in the
capacities and on the dates indicated.
 
 /s/ John
      Arndt
                                      
                                      March 10, 2009John
      Arndt, Secretary/Director
                                      
                                      Date/s/ J. Gerald Bazewicz
                                      
                                      March 10, 2009J.
      Gerald Bazewicz, President/
                                      
                                      DateChief
      Executive Officer/Director/s/ Don E. Bower
                                      
                                      March 10, 2009Don
      E. Bower, Director
                                      
                                      Date/s/ Robert A. Bull
                                      
                                      March 10, 2009Robert
      A. Bull, Director
                                      
                                      Date/s/ Robert E. Bull
                                      
                                      March 10, 2009Robert
      E. Bull, Chairman/Director
                                      
                                      Date/s/ Joseph B. Conahan, Jr.
                                      
                                      March 10, 2009Joseph
      B. Conahan, Jr., Director
                                      
                                      Date/s/ Jerome F. Fabian
                                      
                                      March 10, 2009Jerome
      F. Fabian, Director
                                      
                                      Date/s/ John G. Gerlach
                                      
                                      March 10, 2009John
      G. Gerlach, Director
                                      
                                      Date/s/ Diane C. A. Rosler
                                      
                                      March 10, 2009Diane
      C.A. Rosler, Chief Financial Officer
                                      
                                      Date/s/ David R. Saracino
                                      
                                      March 10, 2009David
      R. Saracino, Director
                                      
                                      Date
  73