**UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**







**FORM
      10-Q**





(Mark
      One)


þ
              **Quarterly
                  report pursuant to Section 13 or 15(d) of the Securities Exchange
                  Act of
                  1934****For
                  the quarterly period ended****September
                  30, 2008**
 
 **OR**
 
 o
              **Transitional
                  report pursuant to Section 13 or 15 (d) of the Securities Exchange
                  Act of
                  1934****For
                  the transition period from ______ to
                  _____**





**Commission
      File Number 0-23971**





**Citizens
      South Banking Corporation**


(Exact
      name of registrant as specified in its charter)





**Delaware**
            
            **54-2069979**(State
                or other jurisdiction of
            
            (I.R.S.
                Employer Identification Number)incorporation
                or organization)





**519
                South New Hope Road, Gastonia, NC**
            
            **28054**(Address
                of principal executive offices)
            
            (Zip
                Code)





**(704)
                868-5200**(Registrant's
                telephone number, including area
                code)





Indicate
      by check mark whether the Registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the Registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days. **Yes**  þ No
o





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 “accelerated filer”, “large accelerated filer” and “small
      reporting company” in Rule 12b-2 of the Exchange Act.





Large
      accelerated filer o  Accelerated
      filer o N on-accelerated
      filer o  Smaller
      Reporting Companyþ





Indicate
      by check mark whether the Registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act.) Yes o  **No** þ





Indicate
      the number of shares outstanding of each of the issuer's classes of common
      stock, as of the latest practicable date.





**Common
      stock, $0.01 par value**


**7,516,816
      shares outstanding as of November 10, 2008**







**Citizens
      South Banking Corporation**


**Index**




Page**PART
                I. — Financial Information**Item
                1. Condensed Consolidated Financial Statements:Condensed
                Consolidated Statements of Financial Condition September 30, 2008
                and
                December 31, 2007
            1Condensed
                Consolidated Statements of Operations for the Three and Nine Months
                Ended
                September 30, 2008 and 2007
            2Condensed
                Consolidated Statements of Comprehensive Income for the Nine Months
                Ended
                September 30, 2008 and 2007
            3Condensed
                Consolidated Statements of Changes in Stockholders’ Equity for the Nine
                Months Ended September 30, 2008 and 2007
            4Condensed
                Consolidated Statements of Cash Flows for the Nine Months Ended September
                30, 2008 and 2007
            5Notes
                to Condensed Consolidated Financial Statements
            6Item
                2. Management's Discussion and Analysis of Financial Condition and
                Results
                of Operations
            9Item
                3. Quantitative and Qualitative Disclosures About Market
                Risk
            20Item
                4. Controls and Procedures
            20**PART
                II — Other Information**
            21Item
                1. Legal Proceedings
            21Item
                1A. Risk Factors
            21Item
                2. Unregistered Sales of Equity Securities and Use of
                Proceeds
            21Item
                3. Defaults Upon Senior Securities
            22Item
                4. Submission of Matters to a Vote of Security Holders
            22Item
                5. Other Information
            22Item
                6. Exhibits
            22Signatures
            22





**PART
      I.**  **FINANCIAL
      INFORMATION**





**ITEM
      1.  Condensed Consolidated Financial Statements**





**Citizens
      South Banking Corporation**


**Condensed
      Consolidated Statements of Financial Condition**


(dollars
      in thousands, except per share data)





**September 30,**
            
            **December 31,****2008**
            
            **2007****(unaudited)****Assets:**Cash
                and cash equivalents
            
            $
            13,924
            
            $
            29,739Investment
                securities available-for-sale, at fair value
            
            
            26,512
            
            
            46,519Mortgage-backed
                and related securities available-for-sale, at fair value
            
            
            81,010
            
            
            69,893Loans:Loans
                receivable, net of unearned income
            
            
            628,496
            
            
            559,956Allowance
                for loan losses
            
            
            (7,027
            )
            
            (6,144
            )Net
                loans
            
            
            621,469
            
            
            553,812Other
                real estate owned
            
            
            1,214
            
            
            529Premises
                and equipment, net
            
            
            17,334
            
            
            17,965Accrued
                interest receivable
            
            
            2,621
            
            
            3,254Federal
                Home Loan Bank stock
            
            
            5,355
            
            
            4,236Intangible
                assets
            
            
            30,635
            
            
            31,037Cash
                value of bank-owned life insurance policies
            
            
            16,635
            
            
            16,099Other
                assets
            
            
            6,321
            
            
            6,057Total
                assets
            
            $
            823,030
            
            $
            779,140**Liabilities
                and Stockholders’ Equity:**Deposits:Demand
                deposit accounts
            
            $
            114,318
            
            $
            101,981Money
                market deposit accounts
            
            
            107,555
            
            
            129,688Savings
                accounts
            
            
            11,288
            
            
            12,037Time
                deposits
            
            
            351,767
            
            
            347,059Total
                deposits
            
            
            584,928
            
            
            590,765Borrowed
                money
            
            
            147,518
            
            
            96,284Deferred
                compensation
            
            
            5,407
            
            
            5,389Other
                liabilities
            
            
            2,350
            
            
            2,669Total
                liabilities
            
            
            740,203
            
            
            695,107Stockholders’
                Equity:Preferred
                stock, $0.01 par value, 1,000,000 shares authorized, none
                issued
            
            
            -
            
            
            -Common
                stock, $0.01 par value, 20,000,000 shares authorized; Issued: 9,062,727
                shares;Outstanding:
                7,516,816 shares at September 30, 2008 and 7,610,017 shares at December
                31, 2007
            
            
            91
            
            
            91Additional
                paid-in-capital
            
            
            67,289
            
            
            67,718Unallocated
                common stock held by Employee Stock Ownership Plan
            
            
            (1,110
            )
            
            (1,247
            )Retained
                earnings
            
            
            36,332
            
            
            36,028Accumulated
                other comprehensive loss, net of deferred income taxes
            
            
            (1,442
            )
            
            (343
            )Treasury
                stock of 1,545,911 shares at September 30, 2008, and 1,452,710 shares
                at
                December 31, 2007, at cost
            
            
            (18,333
            )
            
            (18,214
            )Total
                stockholders’ equity
            
            
            82,827
            
            
            84,033Total
                liabilities and stockholders’ equity
            
            $
            823,030
            
            $
            779,140




***See
      notes to condensed consolidated financial
      statements.***


1


**Citizens
      South Banking Corporation**


**Condensed
      Consolidated**  **Statements
      of Operations** **(unaudited)**


**(in
      thousands, except per share data)**




**Three****Months**
            
            **Nine Months****Ended September 30,**
            
            **Ended September 30,****2008**
            
            **2007**
            
            **2008**
            
            **2007****Interest
                Income:**Loans
            
            $
            9,416
            
            $
            10,377
            
            $
            28,160
            
            $
            30,331Investment
                securities
            
            
            358
            
            
            710
            
            
            1,127
            
            
            2,070Interest-bearing
                deposits
            
            
            13
            
            
            73
            
            
            149
            
            
            342Mortgage-backed
                and related securities
            
            
            1,019
            
            
            783
            
            
            2,825
            
            
            2,150Total
                interest income
            
            
            10,806
            
            
            11,943
            
            
            32,261
            
            
            34,893**Interest
                Expense:**Deposits
            
            
            3,997
            
            
            5,741
            
            
            13,397
            
            
            16,672Borrowed
                funds
            
            
            1,427
            
            
            1,099
            
            
            3,783
            
            
            2,999Total
                interest expense
            
            
            5,424
            
            
            6,840
            
            
            17,180
            
            
            19,671Net
                interest income
            
            
            5,382
            
            
            5,103
            
            
            15,081
            
            
            15,222Provision
                for loan losses
            
            
            720
            
            
            300
            
            
            1,815
            
            
            960Net
                interest income after provision for loan losses
            
            
            4,662
            
            
            4,803
            
            
            13,266
            
            
            14,262**Noninterest
                Income:**Fee
                income on deposit accounts
            
            
            802
            
            
            680
            
            
            2,256
            
            
            2,026Mortgage
                banking income
            
            
            169
            
            
            239
            
            
            650
            
            
            749Income
                on lending activities
            
            
            84
            
            
            116
            
            
            297
            
            
            358Dividends
                on FHLB stock
            
            
            40
            
            
            53
            
            
            168
            
            
            149Increase
                in cash value of bank-owned life insurance
            
            
            195
            
            
            191
            
            
            571
            
            
            578Fair
                value adjustment on deferred compensation assets
            
            
            (12
            )
            
            52
            
            
            (65
            )
            
            110Life
                insurance proceeds, net
            
            
            -
            
            
            -
            
            
            -
            
            
            112Net
                gain on sale of assets
            
            
            14
            
            
            -
            
            
            275
            
            
            336Other
                noninterest income
            
            
            200
            
            
            203
            
            
            613
            
            
            633Total
                noninterest income
            
            
            1,492
            
            
            1,534
            
            
            4,765
            
            
            5,051**Noninterest
                Expense:**Compensation
                and benefits
            
            
            2,565
            
            
            2,461
            
            
            7,665
            
            
            7,167Fair
                value adjustment on deferred comp. obligations
            
            
            (12
            )
            
            52
            
            
            (65
            )
            
            110Occupancy
                and equipment expense
            
            
            662
            
            
            661
            
            
            2,013
            
            
            2,001Professional
                services
            
            
            201
            
            
            127
            
            
            639
            
            
            403Amortization
                of intangible assets
            
            
            126
            
            
            156
            
            
            402
            
            
            483Reorganization
                expenses
            
            
            -
            
            
            -
            
            
            220
            
            
            -Impairment
                of securities
            
            
            468
            
            
            -
            
            
            468
            
            
            162Other
                noninterest expense
            
            
            1,135
            
            
            1,097
            
            
            3,388
            
            
            3,130Total
                noninterest expense
            
            
            5,145
            
            
            4,554
            
            
            14,730
            
            
            13,456Income
                before income taxes
            
            
            1,009
            
            
            1,783
            
            
            3,301
            
            
            5,857Provision
                for income taxes
            
            
            187
            
            
            434
            
            
            647
            
            
            1,519**Net
                income**
            
            **$**
            **822**
            
            **$**
            **1,349**
            
            **$**
            **2,654**
            
            **$**
            **4,338****Net
                income per common share:****Basic**
            
            **$**
            **0.11**
            
            **$**
            **0.18**
            
            **$**
            **0.36**
            
            **$**
            **0.56****Diluted**
            
            **$**
            **0.11**
            
            **$**
            **0.18**
            
            **$**
            **0.36**
            
            **$**
            **0.55****Weighted
                average common shares outstanding:****Basic**
            
            
            **7,358,086**
            
            
            **7,627,620**
            
            
            **7,380,236**
            
            
            **7,748,605****Diluted**
            
            
            **7,386,513**
            
            
            **7,691,722**
            
            
            **7,414,274**
            
            
            **7,817,438**





***See
      notes to condensed consolidated financial
      statements.***


2


**Citizens
      South Banking Corporation**


**Condensed
      Consolidated**  **Statements
      of Comprehensive Income** **(unaudited)**


**(dollars
      in thousands)**





**Nine Months****Ended September 30,****2008**
            
            **2007**Net
                income
            
            $
            2,654
            
            $
            4,338**Items
                of other comprehensive income:**Items
                of other comprehensive income, before taxUnrealized
                holding gains arising during period
            
            
            (1,504
            )
            
            (88
            )Reclassification
                adj. for securities (gains) losses included in net income
            
            
            (284
            )
            
            79Other
                comprehensive loss, before tax
            
            
            (1,788
            )
            
            (9
            )Change
                in deferred income taxes related to changes in unrealized gains or
                losses
                on securities available for sale
            
            
            689
            
            
            4Items
                of other comprehensive loss, net of tax
            
            
            (1,099
            )
            
            (5
            )Comprehensive
                income
            
            **$**
            **1,555**
            
            **$**
            **4,333**





***See
      notes to condensed consolidated financial
      statements.***


3


**Citizens
      South Banking Corporation**


**Condensed
      Consolidated**  **Statements
      of Changes in Stockholders’ Equity** **(unaudited)**


**(dollars
      in thousands)**





**Nine Months****Ended September 30,****2008**
            
            **2007****Common
                stock, $0.01 par value:**At
                beginning of period
            
            $
            91
            
            $
            91Issuance
                of common stock
            
            
            -
            
            
            -At
                end of period
            
            
            91
            
            
            91**Additional
                paid-in-capital:**At
                beginning of period
            
            
            67,718
            
            
            67,439Grant
                of additional shares from Recognition and Retention Plan
                (“RRP”)
            
            
            (720
            )
            
            (128
            )Vesting
                of shares for RRP
            
            
            248
            
            
            226Stock-based
                compensation expense
            
            
            43
            
            
            23At
                end of period
            
            
            67,289
            
            
            67,560**Unallocated
                common stock held by ESOP:**At
                beginning of period
            
            
            (1,247
            )
            
            (1,430
            )Allocation
                from shares purchased with loan from ESOP
            
            
            137
            
            
            137At
                end of period
            
            
            (1,110
            )
            
            (1,293
            )**Retained
                earnings, substantially restricted:**At
                beginning of period
            
            
            36,028
            
            
            33,031Net
                income
            
            
            2,654
            
            
            4,338Accrual
                of post retirement benefits
            
            
            (350
            )
            
            -Exercise
                of options
            
            
            (126
            )
            
            (199
            )Dividends
                paid
            
            
            (1,875
            )
            
            (1,855
            )At
                end of period
            
            
            36,332
            
            
            35,315**Accumulated
                unrealized loss on securities available for sale, net of
                tax:**At
                beginning of period
            
            
            (343
            )
            
            (991
            )Other
                comprehensive income, net of tax
            
            
            (1,099
            )
            
            (5
            )At
                end of period
            
            
            (1,442
            )
            
            (996
            )**Treasury
                stock:**At
                beginning of period
            
            
            (18,214
            )
            
            (12,179
            )Exercise
                of options
            
            
            180
            
            
            283Grant
                of additional shares from RRP
            
            
            720
            
            
            128Purchase
                of common stock for treasury
            
            
            (1,019
            )
            
            (4,531
            )At
                end of period
            
            
            (18,333
            )
            
            (16,299
            )





***See
      notes to condensed consolidated financial
      statements.***


4


**Citizens
      South Banking Corporation**


**Condensed
      Consolidated**  **Statements
      of Cash Flows** **(unaudited)**


**(dollars
      in thousands)**




**Nine Months****Ended September 30,****2008**
            
            **2007****Cash
                flows from operating activities:**Net
                income
            
            $
            2,654
            
            $
            4,338Adjustments
                to reconcile net income to net cash provided by operating
                activities:Provision
                for loan losses
            
            
            1,815
            
            
            960Depreciation
            
            
            836
            
            
            886Impairment
                on investment securities
            
            
            468
            
            
            162Net
                gain on sale of investment securities
            
            
            (125
            )
            
            (1
            )Net
                (gain) loss on sale of mortgage-backed securities
            
            
            (159
            )
            
            80Net
                gain on sale of loans
            
            
            -
            
            
            (5
            )Net
                loss on sale of other real estate owned
            
            
            16
            
            
            9Net
                gain on sale of premises and equipment
            
            
            (7
            )
            
            (419
            )Deferred
                loan origination fees (costs)
            
            
            73
            
            
            (69
            )Allocation
                of shares to the ESOP
            
            
            137
            
            
            137Stock-based
                compensation expense
            
            
            43
            
            
            23Vesting
                of shares for the Recognition and Retention Plan
            
            
            248
            
            
            226Increase
                (decrease) in accrued interest receivable
            
            
            634
            
            
            (476
            )Amortization
                of intangible assets
            
            
            402
            
            
            483(Increase)
                decrease in other assets
            
            
            (1,106
            )
            
            1,567Decrease
                in other liabilities
            
            
            (480
            )
            
            (358
            )Net
                cash provided by operating activities
            
            
            5,449
            
            
            7,543**Cash
                flows from investing activities:**Net
                increase in loans
            
            
            (69,545
            )
            
            (33,184
            )Proceeds
                from the sale of investment securities
            
            
            19,323
            
            
            3,000Proceeds
                from the sale of mortgage-backed securities
            
            
            12,485
            
            
            3,364Proceeds
                from the sale of loans
            
            
            -
            
            
            202Proceeds
                from sale of other real estate owned
            
            
            295
            
            
            233Proceeds
                from sale of premises and equipment
            
            
            15
            
            
            801Maturities
                and prepayments of investment securities
            
            
            2,341
            
            
            9,987Maturities
                and prepayments of mortgage-backed securities
            
            
            11,398
            
            
            9,608Purchases
                of investments
            
            
            (3,659
            )
            
            (9,805
            )Purchases
                of mortgage-backed securities
            
            
            (34,970
            )
            
            (18,208
            )Purchases
                of FHLB stock
            
            
            (1,120
            )
            
            (205
            )Capital
                expenditures for premises and equipment
            
            
            (213
            )
            
            (1,153
            )Net
                cash used in investment activities
            
            
            (63,650
            )
            
            (35,360
            )**Cash
                flows from financing activities:**Net
                increase (decrease) in deposits
            
            
            (5,837
            )
            
            9,312Exercise
                of options
            
            
            54
            
            
            84Post
                retirement benefit accrual
            
            
            (350
            )
            
            -Dividends
                paid
            
            
            (1,875
            )
            
            (1,855
            )Purchase
                of common stock for treasury
            
            
            (1,019
            )
            
            (4,531
            )Net
                increase in borrowed money
            
            
            51,234
            
            
            10,018Increase
                in advances from borrowers for insurance and taxes
            
            
            179
            
            
            228Net
                cash provided by financing activities
            
            
            42,386
            
            
            13,256Net
                decrease in cash and cash equivalents
            
            
            (15,815
            )
            
            (14,561
            )Cash
                and cash equivalents at beginning of period
            
            
            29,739
            
            
            26,221Cash
                and cash equivalents at end of period
            
            $
            13,924
            
            $
            11,660





***See
      notes to condensed consolidated financial
      statements.***


5


**CITIZENS
      SOUTH BANKING CORPORATION**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      1** **–
      Basis of Presentation**





The
      condensed consolidated financial statements of Citizens South Banking
      Corporation (the “Company”) are unaudited and reflect all adjustments of a
      normal recurring nature which are, in the opinion of management, necessary
      for a
      fair presentation of the interim period financial statements as of and for
      the
      three- and nine-month periods ended September 30, 2008 and 2007. Amounts as
      of
      December 31, 2007, included in the condensed consolidated financial statements
      and related notes were derived from the audited consolidated financial
      statements. Results for the three- and nine-month periods ended September 30,
      2008, are not necessarily indicative of the results that may be expected for
      future periods, including the year ending December 31, 2008.





The
      unaudited condensed consolidated financial statements of the Company have been
      prepared pursuant to the rules and regulations of the Securities and Exchange
      Commission, including Rule
      10-01 of Regulation S-X .
      Accordingly, certain information normally included in financial statements
      prepared in conformity with accounting principles generally accepted in the
      United States of America have been condensed or omitted. These condensed
      consolidated financial statements should be read in
      conjunction with the consolidated financial statements and notes thereto in
      the
      Company’s Annual Report on Form 10-K for the year ended December 31,
      2007.





The
      condensed consolidated financial statements include the accounts of Citizens
      South Banking Corporation and the Company’s wholly owned subsidiary, Citizens
      South Bank (the “Bank”).





**Note
      2** **–
      Earnings per Share**





Basic
      earnings per share is calculated by dividing net income by the weighted average
      number of common shares outstanding. Diluted earnings per share is calculated
      by
      dividing net income by the sum of the weighted average number of common shares
      outstanding and potential common stock. Potential common stock consists of
      additional common stock that would have been outstanding as a result of the
      exercise of dilutive stock options. In determining the number of shares of
      potential common stock, the treasury stock method was applied. This method
      assumes that the number of shares issuable upon exercise of the stock options
      is
      reduced by the number of common shares assumed purchased at market prices with
      the proceeds from the assumed exercise of the common stock options plus any
      tax
      benefits received as a result of the assumed exercise. The following is a
      summary of the diluted earnings per share calculation for the three and nine
      months ended September 30, 2008 and 2007:





**Three Months**
            
            **Nine Months****Ended September 30,**
            
            **Ended September 30,****2008**
            
            **2007**
            
            **2008**
            
            **2007****(dollars
                in thousands, except per share amounts)**Net
                income
            
            $
            822
            
            $
            1,349
            
            $
            2,654
            
            $
            4,338Weighted
                average shares outstanding
            
            
            7,358,086
            
            
            7,627,620
            
            
            7,380,236
            
            
            7,748,605Dilutive
                effect of stock options
            
            
            28,427
            
            
            64,102
            
            
            34,038
            
            
            68,833Weighted
                average diluted shares outstanding
            
            
            7,386,513
            
            
            7,691,722
            
            
            7,414,274
            
            
            7,817,438Diluted
                earnings per share
            
            $
            0.11
            
            $
            0.18
            
            $
            0.36
            
            $
            0.55





For
      the
      periods ended September 30, 2008 and 2007, there were 754,290 and 571,751
      shares, respectively, attributed to stock options that were excluded from the
      calculation of diluted earnings per share because their inclusion would have
      been anti-dilutive because the average market price of the stock was below
      the
      strike price on these options.


6


**Note
      3 – Commitments to Extend Credit**





Commitments
      to extend credit are agreements to lend as long as there is no violation of
      any
      condition established in the contract. Commitments generally have fixed
      expiration dates or other termination clauses and may require payment of a
      fee.
      Since commitments may expire without being drawn upon, the total commitment
      amounts do not necessarily represent future cash requirements. These commitments
      represent no more than normal lending risk that the Bank commits to its
      borrowers and management believes that these commitments can be funded through
      normal operations. Commitments to extend credit that include both fixed and
      variable rates are as follows:





September 30, 2008
            
            December 31, 2007Loan
                commitments:Residential
                mortgage loans
            
            $
            6,350,490
            
            $
            7,160,455Non-residential
                mortgage loans
            
            
            3,174,600
            
            
            20,987,431Commercial
                loans
            
            
            1,165,000
            
            
            6,559,700Consumer
                loans
            
            
            2,282,000
            
            
            6,840,137Total
                loan commitments
            
            $
            12,972,090
            
            $
            41,547,723Unused
                lines of credit:Commercial
            
            $
            33,791,244
            
            $
            38,120,483Consumer
            
            
            77,890,622
            
            
            71,831,349Total
                unused lines of credit
            
            $
            111,681,866
            
            $
            109,951,832





**Note
      4** **–
      Dividend Declaration**





On
      October 20, 2008, the Board of Directors of the Company approved and declared
      a
      regular cash dividend of eight and one half cents ($0.085) per share of common
      stock to stockholders of record as of November 1, 2008, payable on November
      15,
      2008.





**Note
      5** **–
      Stock Repurchase Program**





On
      June
      16, 2008, the Board of Directors of the Company authorized the repurchase of
      up
      to 200,000 shares, or approximately 2.7% of the Company’s then outstanding
      shares of common stock. These repurchases may be carried out through open market
      purchases, block trades, and negotiated private transactions. The stock may
      be
      repurchased on an ongoing basis and will be subject to the availability of
      stock, general market conditions, the trading price of the stock, alternative
      uses for capital, and the Company’s financial performance. Under this plan the
      Company had repurchased a total of 9,476 shares at an average price of $7.91
      per
      share and had 190,524 shares remaining to be repurchased at September 30, 2008.
      The Company will consider repurchasing additional shares of common stock of
      the
      Company at prices management considers to be attractive and in the best
      interests of both the Company and its stockholders. Any repurchased shares
      will
      be held as treasury stock and will be available for general corporate
      purposes **.**





**Note
      6 - Recent Accounting Pronouncements**





The
      following is a summary of recent authoritative pronouncements that could impact
      the accounting, reporting, and/or disclosure of financial information by the
      Company.





Effective
      January 1, 2008, the Company adopted Statement of Financial Accounting Standards
      (“SFAS”) No. 157, “ *Fair
      Value Measurements* ”
(“SFAS
      No. 157”), which provides a framework for measuring fair value under GAAP
      and enhances disclosures about fair value measurements. This Statement defines
      fair value as the exchange price that would be received for an asset or paid
      to
      transfer a liability in
      the
      most advantageous market for the asset or liability in an orderly transaction
      between market participants on the measurement date. The Company utilizes fair
      value measurements to record fair value adjustments to certain assets and to
      determine fair value disclosures. The Company has not elected the fair value
      option for liabilities. Available-for-sale securities are recorded at fair
      value
      on a recurring basis. Additionally, the Company may be required to record at
      fair value other assets on a nonrecurring basis. These nonrecurring fair value
      adjustments typically involve the application of lower of cost or market
      accounting for these other assets. At September 30, 2008, the Company did not
      have any loans held for sale.





7


In
      accordance with SFAS No. 157, when measuring fair value, the Company uses
      valuation techniques that are appropriate and consistently applied. A hierarchy
      is used to prioritize valuation inputs into the following three levels to
      determine fair value:




Level
      1:   Quoted
      prices in active markets for identical assets or liabilities.


Level
      2:  Observable
      inputs other than the quoted prices included in Level 1.


Level
      3:  Unobservable
      inputs.





Following
      is a description of valuation methodologies used for assets recorded at fair
      value.





Investment
      Securities Available for Sale





Investment
      securities available-for-sale are recorded at fair value on at least a monthly
      basis. Fair value measurement is based upon quoted prices, if available. If
      quoted prices are not available, fair values are measured using independent
      pricing models or other model-based valuation techniques such as the present
      value of future cash flows, adjusted for the security’s credit rating,
      prepayment assumptions and other factors such as credit loss assumptions. Level
      1 fair value is used for those securities traded on an active exchange and
      U.S.
      Treasury securities that are traded by broker/dealers in an active
      over-the-counter market and money market funds. As of September 30, 2008, the
      Company did not have any securities that were valued using Level 1. Securities
      valued using Level 2 include mortgage-backed securities issued by
      government-sponsored enterprises ($81.0 million), municipal bonds ($23.0
      million), and bonds issued by government agencies ($495,000). Securities valued
      using Level 3 include equity securities that are not actively traded on an
      active exchange ($848,000), investments in closely held subsidiaries ($464,000)
      and asset-backed securities traded in less liquid markets ($1.7 million). The
      fair value measurement as of September 30, 2008, for investment securities
      available-for-sale is summarized below:





Fair
                Value Measurement UsingLevel
                1
            
            Level
                2
            
            Level
                3
            
            Total(in
                thousands)Securities
                available for sale
            
            $
            -
            
            $
            104,478
            
            $
            3,044
            
            $
            107,522


8


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





**Forward
      Looking Statements**





This
      report contains certain forward-looking statements that represent the Company's
      expectations or beliefs concerning future events. Such forward-looking
      statements are based on our current beliefs and expectations and are inherently
      subject to significant business, economic, and competitive uncertainties and
      contingencies, many of which are beyond our control. These forward-looking
      statements are based on assumptions with respect to future business strategies
      and decisions that are subject to change based on changes in the economic and
      competitive environment in which we operate. Forward-looking statements speak
      only as of the date they are made and the Company is under no duty to update
      these forward-looking statements or to reflect the occurrence of unanticipated
      events. A number of factors could cause actual conditions, events, or results
      to
      differ significantly from those described in the forward-looking statements.
      Factors that could cause such a difference include, but are not limited to,
      the
      timing and amount of revenues that may be recognized by the Company, changes
      in
      local or national economic trends, increased competition among depository and
      financial institutions, continuation of current revenue and expense trends
      (including trends affecting chargeoffs and provisions for loan losses), changes
      in interest rates, changes in the shape of the yield curve, and adverse legal,
      regulatory or accounting changes. Because of the risks and uncertainties
      inherent in forward-looking statements, readers are cautioned not to place
      undue
      reliance on these statements. Readers should carefully review the risk factors
      described in other documents the Company files from time to time with the SEC,
      including annual reports on Form 10-K, quarterly reports on Form 10-Q, and
      current reports on Form 8-K.


9


**Overview**





Management’s
      Discussion and Analysis is provided to assist in understanding and evaluating
      the Company’s results of operations and financial condition. The following
      discussion is designed to provide a general overview of the Company’s
      performance for the three- and nine-month periods ended September 30, 2008
      and
      2007. Readers seeking a more in-depth analysis should read the detailed
      discussions below, as well as the condensed consolidated financial statements
      and related notes. Financial highlights are presented in the table
      below.





Three Months
              Ended
              September 30,
              2008
            
            Three Months
              Ended
              September 30,
              2007
            
            % Change
            
            Nine Months
              Ended
              September 30,
              2008
            
            Nine Months
              Ended
              September 30,
              2007
            
            % Change**Earnings:**Net
                interest income
            
            $
            5,382
            
            $
            5,103
            
            
            5.47
            %
            $
            15,081
            
            $
            15,222
            
            
            (0.93)
            %Provision
                for loan losses
            
            
            (720
            )
            
            (300
            )
            
            140.00
            
            
            (1,815
            )
            
            (960
            )
            
            89.06Noninterest
                income
            
            
            1,492
            
            
            1,534
            
            
            (2.74
            )
            
            4,765
            
            
            5,051
            
            
            (5.66
            )Noninterest
                expense
            
            
            (5,145
            )
            
            (4,554
            )
            
            12.98
            
            
            (14,730
            )
            
            (13,456
            )
            
            9.47Income
                tax expense
            
            
            (187
            )
            
            (434
            )
            
            (56.91
            )
            
            (647
            )
            
            (1,519
            )
            
            (57.41
            )**Net
                Income**
            
            **$**
            **822**
            
            **$**
            **1,349**
            
            
            (39.07
            )
            **$**
            **2,654**
            
            **$**
            **4,338**
            
            
            (38.82
            )**Per
                Share Data:**Avg.
                common shares outstanding, basic
            
            
            7,358,086
            
            
            7,627,620
            
            
            (3.53)
            %
            
            7,380,236
            
            
            7,748,605
            
            
            (4.75)
            %Basic
                net income
            
            $
            0.11
            
            $
            0.18
            
            
            (38.89
            )
            $
            0.36
            
            $
            0.56
            
            
            (35.71
            )Avg.
                common shares outstanding, diluted
            
            
            7,386,513
            
            
            7,691,722
            
            
            (3.97)
            %
            
            7,414,274
            
            
            7,817,438
            
            
            (5.16)
            %Diluted
                net income
            
            $
            0.11
            
            $
            0.18
            
            
            (38.89
            )
            $
            0.36
            
            $
            0.55
            
            
            (34.55
            )Cash
                dividends paid
            
            $
            0.085
            
            $
            0.08
            
            
            6.25
            %
            $
            0.255
            
            $
            0.24
            
            
            6.25
            %Period-end
                book value
            
            
            11.02
            
            
            10.86
            
            
            1.47
            
            
            11.02
            
            
            10.86
            
            
            1.47**Financial
                Ratios**(annualized)**:**Return
                on average stockholders’ equity
            
            
            3.97
            %
            
            6.37
            %
            
            (37.68)
            %
            
            4.25
            %
            
            6.83
            %
            
            (37.77)
            %Return
                on average assets
            
            
            0.40
            
            
            0.70
            
            
            (42.86
            )
            
            0.45
            
            
            0.78
            
            
            (42.31
            )Efficiency
                ratio
            
            
            74.85
            
            
            68.61
            
            
            9.09
            
            
            74.22
            
            
            66.37
            
            
            11.83Net
                interest margin
            
            
            3.02
            
            
            3.13
            
            
            (3.51
            )
            
            2.96
            
            
            3.19
            
            
            (7.21
            )Average
                equity to average assets
            
            
            10.09
            
            
            11.09
            
            
            (9.02
            )
            
            10.54
            
            
            11.37
            
            
            (7.30
            )**Asset
                Quality Data:**Allowance
                for loan losses
            
            $
            7,027
            
            $
            6,292
            
            
            11.68
            %
            $
            7,027
            
            $
            6,292
            
            
            11.68
            %Nonperforming
                loans
            
            
            3,335
            
            
            2,528
            
            
            31.92
            
            
            3,335
            
            
            2,528
            
            
            31.92Nonperforming
                assets
            
            
            4,549
            
            
            3,164
            
            
            43.77
            
            
            4,549
            
            
            3,164
            
            
            43.77Net
                charge-offs
            
            
            450
            
            
            136
            
            
            230.88
            
            
            932
            
            
            433
            
            
            115.24Allowance
                for loan losses to total loans
            
            
            1.12
            %
            
            1.15
            %
            
            (2.61
            )
            
            1.12
            %
            
            1.15
            %
            
            (2.61
            )Nonperforming
                loans to total loans
            
            
            0.53
            
            
            0.46
            
            
            15.22
            
            
            0.53
            
            
            0.46
            
            
            15.22Nonperforming
                assets to total assets
            
            
            0.55
            
            
            0.42
            
            
            30.95
            
            
            0.55
            
            
            0.42
            
            
            30.95**Average
                Balances:**Total
                assets
            
            $
            817,613
            
            $
            759,132
            
            
            7.70
            %
            $
            794,066
            
            $
            746,974
            
            
            6.30
            %Loans,
                net of unearned income
            
            
            615,755
            
            
            541,396
            
            
            13.73
            
            
            590,554
            
            
            528,800
            
            
            11.68Interest-earning
                assets
            
            
            724,949
            
            
            668,671
            
            
            8.42
            
            
            700,225
            
            
            653,662
            
            
            7.12Deposits
            
            
            581,162
            
            
            579,141
            
            
            0.35
            
            
            579,810
            
            
            573,373
            
            
            1.12Interest-bearing
                liabilities
            
            
            685,823
            
            
            625,128
            
            
            9.71
            
            
            659,411
            
            
            612,301
            
            
            7.69Stockholders’
                equity
            
            
            82,478
            
            
            83,984
            
            
            (1.79
            )
            
            83,685
            
            
            84,912
            
            
            (1.45
            )**At
                Period End:**Total
                assets
            
            $
            823,030
            
            $
            760,987
            
            
            8.15
            %
            $
            823,030
            
            $
            760,987
            
            
            8.15
            %Loans,
                net of unearned income
            
            
            621,469
            
            
            548,026
            
            
            13.40
            
            
            621,469
            
            
            548,026
            
            
            13.40Interest-earning
                assets
            
            
            732,683
            
            
            666,874
            
            
            8.25
            
            
            732,683
            
            
            676,874
            
            
            8.25Deposits
            
            
            584,928
            
            
            572,114
            
            
            2.24
            
            
            584,928
            
            
            572,114
            
            
            2.24Interest-bearing
                liabilities
            
            
            691,600
            
            
            628,084
            
            
            10.11
            
            
            691,600
            
            
            628,084
            
            
            10.11Stockholders’
                equity
            
            
            82,827
            
            
            84,378
            
            
            (1.84
            )
            
            82,827
            
            
            84,378
            
            
            (1.84
            )


10


**Critical
      Accounting Policies**





The
      accounting and reporting policies of the Company and its subsidiaries are based
      on accounting principles generally accepted in the United States and conform
      to
      general practices in the banking industry. We consider a critical accounting
      policy to be one that is both very important to the portrayal of the Company’s
      financial condition and results of operations and requires a difficult,
      subjective or complex judgment by management. What makes these judgments
      difficult, subjective and/or complex is the need to make estimates about the
      effects of matters that are inherently uncertain. Changes in underlying factors,
      assumptions or estimates could have a material impact on our future financial
      condition and results of operations. Based on the size of the item or
      significance of the estimate, our critical accounting and reporting policies
      include our accounting for the allowance for loan losses and evaluation of
      other-than-temporary impairment of investments.





**Allowance
      for Loan Losses.** The
      allowance for loan losses is calculated with the objective of maintaining an
      allowance sufficient to absorb estimated probable loan losses. Management’s
      determination of the adequacy of the allowance is based on quarterly evaluations
      of the loan portfolio and other relevant factors. However, this evaluation
      is
      inherently subjective, as it requires an estimate of the loss for each type
      of
      loan and for each impaired loan, an estimate of the amounts and timing of
      expected future cash flows, and an estimate of the value of the
      collateral.





Management
      has established a systematic method for periodically evaluating the credit
      quality of the loan portfolio in order to establish an allowance for loan
      losses. The methodology is set forth in a formal policy and includes a review
      of
      all loans in the portfolio on which full collectibility may or may not be
      reasonably assured. The loan review considers among other matters, the estimated
      fair value of the collateral, economic conditions, historical loan loss
      experience, our knowledge of inherent losses in the portfolio that are probable
      and reasonably estimable and other factors that warrant recognition in providing
      an appropriate loan loss allowance. Specific allowances are established for
      certain individual loans that management considers impaired under SFAS No.
      114,
“ *Accounting
      by Creditors for Impairment of a Loan.”* The
      remainder of the portfolio is segmented into groups of loans with similar risk
      characteristics for evaluation and analysis. In originating loans, we recognize
      that losses will be experienced and that the risk of loss will vary with, among
      other things, the type of loan being made, the creditworthiness of the borrower,
      the term of the loan, general economic conditions, and in the case of a secured
      loan, the quality of the collateral. We increase our allowance for loan losses
      by charging provisions for loan losses against our current period income.
      Management’s periodic evaluation of the adequacy of the allowance is
      consistently applied and is based on our past loan loss experience, particular
      risks inherent in the different kinds of lending that we engage in, adverse
      situations that may affect the borrower’s ability to repay, the estimated value
      of any underlying collateral, current economic conditions, and other relevant
      internal and external factors that affect loan collectibility. Management
      believes this is a critical accounting policy because this evaluation involves
      a
      high degree of complexity and requires us to make subjective judgments that
      often require assumptions or estimates about various matters.





**Other-Than-Temporary
      Impairment of Securities.** Management
      periodically reviews all investment securities with significant declines in
      fair
      value for potential other-than-temporary impairment pursuant to the guidance
      provided by SFAS No. 115, “ *Accounting
      for Certain Investments in Debt and Equity Securities”.* In
      November 2006, the FASB issued Staff Position (“FSP”) FAS 115-1 and FAS 124-1,
“ *The
      Meaning of Other-Than-Temporary Impairment and Its Application to Certain
      Investments.* ”
The
      FSP
      addressed the determination as to when an investment is considered impaired,
      whether the impairment is other-than-temporary, and the measurement of an
      impairment loss. It also included accounting considerations subsequent to the
      recognition of an other-than-temporary impairment and requires certain
      disclosures about unrealized losses that have not been recognized as
      other-than-temporary impairments. The guidance in this FSP amended SFAS No.
      115 *“Accounting
      for Certain Investments in Debt and Equity Securities”,* No.
      124,
“ *Accounting
      for Certain Investments Held by Not-for-Profit Organizations”,* and
      APB
      Opinion 18, “ *The
      Equity Method of Accounting for Investments in Common Stock”.*





11


Effective
      September 30, 2008, management evaluated the Company’s investment portfolio and
      determined that the $468,000 impairment on a $1.0 million trust preferred
      collateralized debt obligation was other-than-temporary. This investment is
      collateralized by trust preferred securities that were issued by a pool of
      40
      banks operating throughout the country. Management determined that the
      impairment was other-than-temporary because 1) two of the original 40 banks
      had
      defaulted on their payments; 2) the security, which had an original credit
      rating of “A-”, was on negative watch and subject to downgrade by one or more of
      the credit rating agencies; and 3) the interest rate of LIBOR plus 105 basis
      points on this security was well below the current pricing for bank capital
      which approximated LIBOR plus 400 basis points at September 30, 2008. Management
      determined that it was unlikely that the pricing for bank capital would return
      to a level consistent with the pricing on the Company’s security in the
      foreseeable future. Due to the lack of liquidity for this type of security
      in
      the current environment, the security was valued using Level 3. The fair value
      was prepared by an independent third party using a discounted cash flow model
      using various default assumptions ranging from 10% to 40%. The fair value of
      $532,000 was determined based on a weighted average of the various default
      assumptions, with the 20% default rate as the most likely scenario over the
      life
      of the security. The current default rate on this security is
      5.25%.





All
      other
      unrealized losses were determined by management to be the result of temporary
      changes in interest rates, pricing spreads, and market conditions that could
      be
      recovered in the foreseeable future. The Company has the ability to hold these
      investments to maturity if necessary in order to recover any temporary losses
      that may presently exist. As a result, management did not consider any
      additional unrealized losses as other-than-temporary as of September 30, 2008.





**Comparison
      of Financial Condition**





*Assets.* Total
      assets of the Company increased by $43.9 million, or 5.6%, from $779.1 million
      at December 31, 2007, to $823.0 million at September 30, 2008. This increase
      was
      primarily due to a $68.5 million, or 12.2%, increase in loans receivable to
      $628.5 million at September 30, 2008. The growth in loans was primarily
      comprised of a $27.7 million, or 33.7%, increase in consumer loans to $109.7
      million, a $34.6 million, or 12.6%, increase in commercial real estate loans
      to
      $308.3 million, a $1.0 million, or 3.0%, increase in commercial business loans
      to $34.2 million, and a $7.0 million, or 9.0%, increase in residential loans
      to
      $85.0 million. These increases in loans were partly offset by a $2.8 million,
      or
      3.2%, decrease in residential and commercial construction loans to $86.5
      million. Loan production remained strong during the first nine months of 2008,
      totaling $216.1 million, compared to $234.7 million during the first nine months
      of 2007. The economy in the Charlotte region remains relatively stable compared
      to other regions of the country; however, housing starts and demand for
      commercial real estate have slowed during 2008. As a result, management expects
      that loan growth will slow during the remainder of 2008. Management will seek
      to
      continue to grow the loan portfolio in a prudent manner with an emphasis on
      borrowers that have a demonstrated capacity to meet their debt obligations,
      even
      as the local economy slows.





As
      of
      September 30, 2008, $268.2 million, or 43.1%, of the Company’s loan portfolio,
      was scheduled to reprice in one month. This sensitivity to falling short-term
      interest rates was a factor in the Company’s margin compression during the first
      half of 2008 as the prime rate decreased by 275 basis points during the period.
      However, during the third quarter of 2008, there were no decreases in short-term
      interest rates and a large number of time deposits repriced at lower rates,
      resulting in a decreased cost of funds. As a result, the Company’s net interest
      margin improved by 11 basis points from 2.91% for the second quarter of 2008
      to
      3.02% for the third quarter of 2008. However, the recent 50 basis point decrease
      in short-term interest rates in the fourth quarter of 2008 by the Federal
      Reserve will likely result in margin compression for the fourth quarter of
      2008.





Cash
      and
      cash equivalents decreased by $15.8 million, or 53.2%, from $29.7 million at
      December 31, 2007, to $13.9 million at September 30, 2008. This decrease was
      primarily attributable to loan growth of $68.5 million, an $11.1 million
      increase in mortgage-backed securities (“MBS”) and decreases in deposits of $5.8
      million. These outlays of cash were partly offset by a $20.0 million decrease
      in
      investment securities and a $51.2 million increase in borrowed money. Management
      expects that the level of cash and cash equivalents will remain relatively
      stable through the remainder of 2008. Proceeds needed to fund future loan growth
      are expected to be generated from growth in deposits, maturing investments
      and
      MBS and / or additional borrowings.





During
      the nine-month period ended September 30, 2008, investment securities decreased
      by $20.0 million, or 43.0%, to $26.5 million. The decrease in investment
      securities was primarily due to normal maturities of $2.3 million and the sale
      of $19.3 million of investment securities during the period. These decreases
      in
      investment securities were partly offset by the purchase of $3.7 million of
      investment securities during the period. MBS increased $11.1 million, or 15.9%,
      to $81.0 million. The increase in MBS was due to the purchase of $35.0 million
      of MBS during the period, the effects of which were partly offset by the sale
      of
      $12.5 million in MBS and by $11.4 million of normal principal amortization.
      The
      investment securities and MBS were primarily sold to fund loan growth.
      Management expects the investment and MBS portfolios to decrease as a percentage
      of total assets as the cash flows generated from these investments and MBS
      are
      used to fund loan growth or repay borrowings. This rebalancing of the balance
      sheet from lower-yielding cash and cash equivalents, investments, and MBS to
      higher-yielding loans is expected to be a positive factor in improving the
      Company’s net interest margin.





12


Other
      real estate owned, which consisted of 14 one-to-four family residential
      dwellings, one residential lot, and one commercial building acquired by the
      Bank
      through foreclosure, totaled $1.2 million at September 30, 2008, compared to
      $529,000 at December 31, 2007. All foreclosed properties are written down to
      their estimated fair value at acquisition, and are located in the Bank’s primary
      lending area. Management will continue to aggressively market foreclosed
      properties for a timely disposition.





*Allowance
      for loan losses and nonperforming assets.* The
      Company has established a systematic methodology for determining the adequacy
      of
      the allowance for loan losses as previously discussed. The allowance for loan
      losses is increased by charging provisions for loan losses against income.
      As of
      September 30, 2008, the allowance for loan losses was $7.0 million, or 1.12%
      of
      total loans. Management believes that this amount meets the requirement for
      losses on loans that management considers to be impaired, for known losses,
      and
      for losses inherent in the remaining loan portfolio. Although management
      believes that it uses the best information available to make such
      determinations, future adjustments to the allowance for loan losses may be
      necessary and results of operations could be significantly adversely affected
      if
      circumstances differ substantially from the assumptions used in making the
      determinations. The following table presents an analysis of changes in the
      allowance for loan losses for the comparable periods and information with
      respect to nonperforming assets at the dates indicated.





**At and For the Three**
            
            **At and For the Nine****Months Ended September 30,**
            
            **Months Ended September 30,****2008**
            
            **2007**
            
            **2008**
            
            **2007**(dollars
                  in thousands)
            
            (dollars
                in thousands)**Allowance
                for loan losses:**Beginning
                of period
            
            $
            6,757
            
            $
            6,128
            
            $
            6,144
            
            $
            5,764Add:Provision
                for loan losses
            
            
            720
            
            
            300
            
            
            1,815
            
            
            960Recoveries
            
            
            3
            
            
            66
            
            
            52
            
            
            86Less:Charge-offs
            
            
            453
            
            
            202
            
            
            984
            
            
            519End
                of period
            
            $
            7,027
            
            $
            6,292
            
            $
            7,027
            
            $
            6,292Nonaccrual
                loans
            
            $
            3,335
            
            $
            2,528
            
            $
            3,335
            
            $
            2,528Real
                estate owned
            
            
            1,214
            
            
            636
            
            
            1,214
            
            
            636Nonperforming
                assets
            
            $
            4,549
            
            $
            3,164
            
            $
            4,549
            
            $
            3,164Allowance
                for loan losses as a percentage of total loans
            
            
            1.12
            %
            
            1.15
            %
            
            1.12
            %
            
            1.15
            %Nonperforming
                loans to total loans
            
            
            0.53
            %
            
            0.46
            %
            
            0.53
            %
            
            0.46
            %Nonperforming
                assets to total assets
            
            
            0.55
            %
            
            0.42
            %
            
            0.55
            %
            
            0.42
            %








Premises
      and equipment decreased by $631,000, or 3.5%, to $17.3 million at September
      30,
      2008. During 2008, the Company opened a full-service office located in a leased
      facility in Rock Hill, South Carolina. Also during 2008, the Company closed
      its
      mortgage loan production office and consolidated the operations of its two
      commercial loan production offices into existing branch facilities. As a result,
      there were no loan production offices operating as of September 30, 2008. This
      consolidation of loan production offices was a cost cutting measure that was
      done as a part of the Company’s reorganization efforts during the first quarter
      of 2008. No significant changes to the Company’s premises and equipment are
      anticipated for the remainder of 2008.





13


*Liabilities* .
      Total
      liabilities increased by $45.1 million, or 6.5%, from $695.1 million at December
      31, 2007, to $740.2 million at September 30, 2008. This increase was primarily
      due to a $51.2 million increase in borrowed money which was partly offset by
      a
      $5.8 million decrease in total deposits.





While
      total deposits decreased by $5.8 million, or 1.0%, to $584.9 million at
      September 30, 2008, demand deposit accounts (checking accounts) increased by
      $12.3 million, or 12.1%, to $114.3 million at September 30, 2008. The increase
      in demand deposit accounts was primarily due to a continued emphasis on
      increasing the Company’s number of retail and business customers through
      employee incentive plans and enhanced treasury service products. Also, time
      deposits increased by $4.7 million, or 1.4%, to $351.8 million at September
      30,
      2008. The increase in demand deposit accounts and time deposits was offset
      by a
      $22.1 million, or 17.1%, decrease in money market deposit accounts to $107.6
      million and a $749,000, or 6.2%, decrease in savings accounts to $11.3 million
      at the end of the reporting period. The decrease in these interest-sensitive
      money market deposit accounts was largely due to the Company’s action to
      aggressively lower its deposit rates more quickly than some of its competitors
      in response to the Federal Reserve Board’s actions to lower the federal funds
      rate by 225 basis points during the nine-month period ended September 30, 2008.
      The Company will continue to actively market the Company’s deposit products at
      pricing points that management believes to be profitable. Management has always
      focused on increasing deposits by building customer relationships and typically
      avoids growing deposits by offering the highest rates in the market. The Company
      opened its 15 th full-service office in Rock Hill, South Carolina during the first quarter of
      2008. This additional office, the Company’s first in South Carolina, will be an
      integral part of the Company’s efforts to continue growing core deposits and
      market share in the Charlotte region. However, if loan growth continues to
      significantly outpace deposit growth, management may be more aggressive in
      pricing retail deposits, which may increase the Company’s cost of funds. In
      addition, management may use brokered deposits to fund future loan growth if
      additional liquidity is needed. Brokered deposits totaled $12.4 million, or
      2.1%
      of total deposits, at September 30, 2008, compared to $3.6 million, or 0.6%,
      of
      total deposits at December 31, 2007.





Borrowed
      money increased by $51.2 million, or 53.2%, to $147.5 million at September
      30,
      2008. This increase was primarily due to additional Federal Home Loan Bank
      (“FHLB”) advances that were obtained primarily for the purpose of funding loan
      growth and $20.0 million in repurchase agreements with Citigroup Global Market,
      Inc. that were used to purchase MBS. Additional borrowed money may be used
      in
      the future to fund additional loan growth or purchase investment or
      mortgage-backed securities. However, maturing advances will generally be repaid
      if there is a sufficient level of cash and cash equivalents.





*Stockholders’
      Equity* .
      Total
      stockholders’ equity decreased by $1.2 million, or 1.4%, from $84.0 million at
      December 31, 2007, to $82.8 million at September 30, 2008. The decrease in
      stockholders’ equity was partly due to a $1.1 million increase in unrealized
      losses on available-for-sale investment securities and MBS. This increase in
      unrealized losses was primarily due to increases in long-term interest rates
      and
      higher spreads resulting from increased volatility in the securities markets.
      With the exception of the $468,000 other-than-temporary impairment that was
      discussed earlier in the “Critical Accounting Policies” section of this report,
      management expects that these losses are temporary in nature and that the market
      value of the securities portfolio will recover in the foreseeable future.





Also,
      during the nine-month period the Company repurchased 102,828 shares of common
      stock at an average cost of $9.91 per share, resulting in a $1.0 million
      decrease in stockholders’ equity. On October 22, 2007, the Board of Directors
      authorized the repurchase of up to 200,000 shares, or approximately 2.5%, of
      the
      then outstanding shares of common stock. This repurchase plan was completed
      in
      June 2008. An additional repurchase plan was authorized by the Board of
      Directors on June 16, 2008. The new plan authorized the repurchase of 200,000
      shares, or approximately 2.7% of the Company’s then outstanding shares of common
      stock. These repurchases may be carried out through open market purchases,
      block
      trades, and negotiated private transactions. The stock may be repurchased on
      an
      ongoing basis and will be subject to the availability of stock, general market
      conditions, the trading price of the stock, alternative sources and uses for
      capital, and the Company’s financial performance. Under the current plan the
      Company had repurchased a total of 9,476 shares at an average price of $7.91
      per
      share and had 190,524 shares remaining to be repurchased at September 30, 2008.
      Any repurchased shares will be held as treasury stock and will be available
      for
      general corporate purposes **.**





14


In
      addition, stockholders’ equity was decreased by the payment of $1.9 million in
      cash dividends during the nine-month period, representing $0.255 per outstanding
      share. These decreases in shareholders’ equity were partly offset by $2.7
      million in net income during the nine-month period ended September 30,
      2008.





**Comparison
      of Results of Operations for the Three Months Ended September 30, 2008 and
      2007**





*General* .
      Net
      income for the three months ended September 30, 2008, amounted to $822,000,
      or
      $0.11 per diluted share, as compared to $1.3 million, or $0.18 per diluted
      share, for the three months ended September 30, 2007. This represented a 39.1%
      decrease in net income and a 38.9% decrease in diluted earnings per share for
      the comparable periods. This decrease was largely due to an additional $420,000
      in the provision for loan losses resulting from a $314,000 increase in net
      loan
      losses during the third quarter of 2008 and a $468,000 other-than-temporary
      impairment on a $1.0 million trust preferred collateralized debt obligation
      that
      was charged against earnings during the third quarter of 2008.





*Net
      interest income.* Interest
      income decreased by $1.1 million, or 9.5%, to $10.8 million for the third
      quarter of 2008, primarily as a result of a lower market rates due to a 275
      basis point decrease in short-term interest rates from September 30, 2007 to
      September 30, 2008. As of September 30, 2008, approximately 43% of the Company’s
      loan portfolio was scheduled to reprice on a monthly basis. Average
      interest-earning assets increased by $56.3 million, or 8.4%, to $724.9 million
      for the three months ended September 30, 2008. The increase in average
      interest-earning assets was primarily the result of a $74.4 million, or 13.7%,
      increase in average outstanding loans to $615.8 million for the quarter ended
      September 30, 2008. The increase in average loans was partly offset by an $18.3
      million, or 15.2%, decrease in average investments and MBS. The Company’s
      average yield on earning assets decreased by 119 basis points to 5.99% for
      the
      quarter ended September 30, 2008, as a result of lower interest rates during
      the
      comparable periods. Interest expense decreased by $1.4 million, or 20.7%, for
      the comparable quarters to $5.4 million for the third quarter of 2008. This
      decrease in interest expense was largely due to lower market interest rates.
      As
      a result, the average cost of funds decreased by 121 basis points to 3.13%
      for
      the quarter ended September 30, 2008. The benefits of lower market rates were
      partly offset by a $60.7 million, or 9.7%, increase in the average balance
      of
      interest-bearing liabilities to $685.8 million for the three months ended
      September 30, 2008. Average interest-bearing liabilities increased primarily
      as
      a result of a $59.9 million, or 70.4%, increase in average borrowed money
      coupled with a $750,000, or 0.14%, increase in average interest-bearing
      deposits.





As
      a
      result of the decrease in interest rates during the comparable periods, the
      tax-equivalent net interest margin decreased by 11 basis points to 3.02% for
      the
      quarter ended September 30, 2008, compared to 3.13% for the quarter ended
      September 30, 2007. This decrease in the tax-equivalent net interest margin
      was
      primarily the result of yields on earning assets falling at a faster rate than
      the cost of funds. On a linked-quarter basis, the Company’s tax-equivalent net
      interest margin increased 11 basis points from 2.91% for the second quarter
      of
      2008 to 3.02% for the third quarter of 2008. While the Company maintains a
      relatively neutral interest rate risk position on a cumulative one-year basis,
      a
      decrease in short-term interest rates would have a more pronounced negative
      impact in the first three months following the decrease. The short-term negative
      effects of a decrease in interest rates are expected to be mostly offset by
      time
      deposits that mature over the next 12 months and reprice at a lower cost to
      the
      Company.





*Provision
      for loan losses.* The
      provision for loan losses amounted to $720,000 for the third quarter of 2008
      compared to $300,000 for the third quarter of 2007, representing a $420,000
      increase. The primary reason for the increase was $314,000 in additional
      write-offs that were realized during the third quarter of 2008 as compared
      to
      the third quarter of 2007. The increase in write-offs was primarily due to
      the
      slowing local housing market. As a result of these write-offs, the Company
      increased the amount of the provision for loan losses in order to maintain
      an
      adequate level of allowance for loan losses. The allowance for loan losses
      was
      $7.0 million, or 1.12% of total loans as of September 30, 2008, compared to
      $6.3
      million, or 1.15% of total loans as of September 30, 2007. Credit quality
      continued to compare favorably with industry peers with a ratio of nonperforming
      loans to total loans of 0.53% on September 30, 2008, compared to 0.46% on
      September 30, 2007. A substantial portion of the Company’s nonperforming loans
      at September 30, 2008, was secured by real estate located in the Company’s
      primary lending market. In addition, the Company’s ratio of nonperforming assets
      to total assets was 0.55% at September 30, 2008, compared to 0.42% at September
      30, 2007. Net chargeoffs totaled $450,000, or 0.07% of average loans, during
      the
      third quarter of 2008 compared to $136,000, or 0.02% of average loans, during
      the third quarter of 2007.




15


*Noninterest
      income.* Noninterest
      income decreased by $42,000, or 2.7%, to $1.5 million for the three months
      ended
      September 30, 2008. The change in noninterest income was largely attributable
      to
      decreases in fee income on mortgage banking activities, fee income on lending
      activities, dividends on FHLB stock, other noninterest income, and fair value
      adjustments on deferred compensation assets. The slowdown in the local housing
      market was primarily responsible for a decrease in mortgage lending activity
      and
      residential construction loan closings. As a result, fee income on mortgage
      banking activities and lending activities was down by $70,000 and $32,000,
      respectively, from the third quarter of 2007 to the third quarter of 2008.
      Reductions in short-term interest rate reductions by the Federal Reserve over
      the past 12 months contributed to a $13,000 reduction in dividends received
      on
      FHLB stock. Other noninterest income was down $3,000 in part due to lower
      commissions on the sale of uninsured deposit products. The $64,000 decrease
      in
      the fair value of deferred compensation assets was directly offset by a decrease
      in noninterest expense, resulting in no net impact on the earnings of the
      Company.





These
      decreases in noninterest income were partly offset by a $122,000 increase in
      fee
      income on deposit accounts, a $4,000 increase in the cash value of bank-owned
      life insurance, and a $14,000 net gain on the sale of assets. An increase in
      the
      number of demand deposit customers contributed to the improvement in deposit
      fee
      income. The Company remains focused on increasing the number of demand deposit
      accounts in the future. The $14,000 increase in the net gain on sale of assets
      resulted from a $1,000 net gain on the sale of $5.8 million in investment
      securities, a $6,000 net gain on the sale of $112,000 in real estate owned,
      and
      a $7,000 net gain on the sale of $15,000 in miscellaneous fixed
      assets.





*Noninterest
      expense.* Noninterest
      expense increased by $591,000, or 13.0%, to $5.1 million for the quarter ended
      September 30, 2008, compared to $4.6 million for the quarter ended September
      30,
      2007. The primary reason for the increase was a $468,000 other-than-temporary
      impairment charge on a $1.0 million trust preferred collateralized debt
      obligation during the third quarter of 2008. This investment is discussed above
      in the section “Other-Than-Temporary Impairment of Securities”.




Other
      increases in noninterest expense included a $104,000, or 4.2%, increase in
      compensation and benefits, a $1,000, or 0.2%, increase in occupancy and
      equipment expense, a $74,000, or 58.3%, increase in professional services,
      and a
      $38,000, or a 3.5%, increase in other noninterest expenses. Management hired
      several experienced lenders and an experienced credit officer during 2007 which
      contributed to the increase in compensation and benefits. However, we expect
      that the additional loan growth associated with these new positions will
      generate revenue to offset the additional compensation expense in 2008. The
      Company also opened its 15th full-service office in Rock Hill, South Carolina,
      during the first quarter 2008, which resulted in an increase in office occupancy
      and equipment expense. However, this increase has been tempered by the
      consolidation of the Company’s three loan production offices into existing
      branch facilities. The increase in professional services was primarily
      associated with higher audit-related costs, consulting fees and legal services.
      Management expects that these expenses will decrease for the remainder of 2008.
      Other noninterest expenses increased as a result of higher expenses related
      to
      data processing and technology, deposit operations, and loan collection and
      administration. A portion of the increase was related to the opening of the
      new
      office during the first quarter of 2008.





These
      increases in noninterest expense were partly offset by a $64,000 decrease in
      the
      fair value adjustment on deferred compensation and a $30,000, or 19.2%, decrease
      in the amortization expense of intangible assets. The decrease in the fair
      value
      adjustment on deferred compensation was directly offset by a corresponding
      decrease to noninterest income, resulting in no net impact to the Company.
      The
      amortization of intangible assets is expected to continue to decrease as the
      amount of the core deposit intangible decreases.




16


*Income
      taxes.* Income
      taxes amounted to $187,000, or 18.5% of taxable income, for the quarter ended
      September 30, 2008, as compared to $434,000, or 24.3% of taxable income, for
      the
      quarter ended September 30, 2007. The decrease in the effective tax rate during
      the comparable periods was primarily due to a $774,000 decrease in income before
      income taxes. In addition, tax equivalent adjustments increased from 34.7%
      of
      net income for the quarter ended September 30, 2007, to 47.9% of net income
      for
      the quarter ended September 30, 2008. This nontaxable income was primarily
      generated from interest earned on bank-qualified municipal securities and loans.
      The Company invests in tax-advantaged sources of income to reduce its overall
      tax burden. However, as the Company continues to increase the amount of income
      derived from interest income on loans and fee income on loans and deposits,
      the
      effective tax rate is expected to increase.





**Comparison
      of Results of Operations for the Nine Months Ended September 30, 2008 and
      2007**





*General* .
      Net
      income for the nine months ended September 30, 2008, amounted to $2.7 million,
      or $0.36 per diluted share, as compared to $4.3 million, or $0.55 per diluted
      share, for the nine months ended September 30, 2007. This represented a 38.8%
      decrease in net income and a 34.6% decrease in diluted earnings per share for
      the comparable periods. This decrease was largely due to an additional $855,000
      in the provision for loan losses resulting from a $499,000 increase in net
      loan
      losses during the third quarter of 2008 and a $468,000 other-than-temporary
      impairment on a $1.0 million trust preferred collateralized debt obligation
      that
      was charged against earnings during the third quarter of 2008.





*Net
      interest income.* Interest
      income decreased by $2.6 million, or 7.5%, to $32.3 million for the nine months
      ended September 30, 2008, primarily as a result of lower short-term interest
      rates. As of September 30, 2008, approximately 43% of the Company’s loan
      portfolio was scheduled to reprice on a monthly basis. Average interest-earning
      assets increased by $46.6 million, or 7.1%, to $700.2 million for the nine
      months ended September 30, 2008. The increase in average interest-earning assets
      was primarily the result of a $61.8 million, or 11.7%, increase in average
      outstanding loans to $590.6 million. This increase was partly offset by a $16.3
      million, or 11.9%, decrease in average investments and MBS during the comparable
      periods. Due to decreases in short-term interest rates over the past 12 months,
      the Company’s average yield on earning assets decreased by 100 basis points to
      6.22% for the nine months ended September 30, 2008. Interest expense decreased
      by $2.5 million, or 12.7%, for the comparable periods to $17.2 million for
      the
      nine months ended September 30, 2008. This decrease in interest expense was
      largely due to lower market interest rates. As a result, the average cost of
      funds decreased by 81 basis points to 3.48% for the nine months ended September
      30, 2008. The benefit of lower interest rates was partly offset by a $47.1
      million, or 7.7%, increase in the average balance of interest-bearing
      liabilities to $659.4 million for the nine months ended September 30, 2008.
      Average interest-bearing liabilities increased primarily as a result of a $42.0
      million, or 53.7%, increase in borrowed money coupled with a $5.1 million,
      or
      1.0%, increase in average interest-bearing deposits.





As
      a
      result of the decrease in interest rates during the comparable periods, the
      tax-equivalent net interest margin decreased by 23 basis points to 2.96% for
      the
      nine months ended September 30, 2008, compared to 3.19% for the nine months
      ended September 30, 2007. This decrease in the net interest margin was primarily
      the result of yields on earning assets falling at a faster rate than the cost
      of
      funds. While the Company maintains a relatively neutral interest rate risk
      position on a cumulative one-year basis, decreases in short-term interest rates
      would have a more pronounced negative impact in the first three months. The
      short-term negative effects of a decrease in interest rates are expected to
      be
      mostly offset by time deposits that mature over the next 12 months and reprice
      at a lower cost to the Company.





*Provision
      for loan losses.* The
      provision for loan losses amounted to $1.8 million for the nine months ended
      September 30, 2008, compared to $960,000 for the nine months ended September
      30,
      2007, representing an $855,000 increase. The primary reason for the increase
      was
      $499,000 in additional net chargeoffs that were realized during the first nine
      months of 2008 as compared to the first nine months of 2007. The increase in
      net
      chargeoffs was primarily due to the slowing local housing market. As a result,
      the Company increased the amount of the provision for loan losses in order
      to
      maintain an adequate level of the allowance for loan losses. The allowance
      for
      loan losses was $7.0 million, or 1.12% of total loans as of September 30, 2008,
      compared to $6.3 million, or 1.15% of total loans as of September 30, 2007.
      Credit quality continues to compare favorably with industry peers with a ratio
      of nonperforming loans to total loans of 0.53% on September 30, 2008, compared
      to 0.46% on September 30, 2007. A substantial portion of the Company’s
      nonperforming loans at September 30, 2008, was secured by real estate located
      in
      the Company’s primary lending market. In addition, the Company’s ratio of
      nonperforming assets to total assets was 0.55% at September 30, 2008, compared
      to 0.42% at September 30, 2007. Net chargeoffs totaled $932,000, or 0.16% of
      average loans, during 2008 compared to $433,000, or 0.08% of average loans,
      during 2007.




17


*Noninterest
      income.* Noninterest
      income decreased by $286,000, or 5.7%, to $4.8 million for the nine months
      ended
      September 30, 2008, as compared to $5.0 million for the nine months ended
      September 30, 2007. This decrease was largely attributable to a $99,000, or
      13.2%, decrease in fee income on mortgage banking activities, a $61,000, or
      17.0%, decrease in fee income on lending activities, a $7,000, or 1.2%, decrease
      in cash value on bank-owned life insurance, a $20,000, or 3.1%, decrease in
      other noninterest income and a $175,000 decrease in the fair value adjustment
      on
      deferred compensation assets. The income generated from mortgage banking
      activities decreased due to a reduction in mortgage lending activity in the
      Charlotte region. However, the residential real estate market in the Charlotte
      region remains relatively active and is expected to provide the Company with
      continued opportunities for growth in the future. The decrease in fee income
      on
      lending activities was largely the result of originating fewer construction
      and
      acquisition and development loans during 2008. These loans typically generate
      higher fee income than other types of loans. Cash value on bank owned life
      insurance decreased slightly due to lower market rates during the comparable
      periods. The decrease in other noninterest income was primarily due to lower
      commissions on the sale on uninsured deposit products. The decrease in the
      fair
      value on deferred compensation assets was directly offset by a decrease in
      noninterest expense, resulting in no net impact on the earnings of the Company.





In
      addition, the Company experienced a $61,000 decrease in the net gain on sale
      of
      assets and an $112,000 decrease in net life insurance proceeds payable to the
      Company. The Company recognized $275,000 in net gains from the sale of assets
      during the nine months ended September 30, 2008, compared to $336,000 during
      the
      nine months ended September 30, 2007. During the first nine months of 2008
      the
      Company sold $19.3 million of investment securities at a net gain of $125,000
      and $12.5 million of mortgage-backed securities at a net gain of $159,000.
      These
      securities were primarily sold to generate proceeds to fund loan growth. In
      addition, during the nine months ended September 30, 2008, the Company sold
      $295,000 in other real estate owned at a loss of $16,000 and sold $15,000 of
      miscellaneous fixed assets at a net gain of $7,000. During the nine months
      ended
      September 30, 2007, the Company sold $801,000 in real estate including a small
      portion of land from an existing branch office site and a vacant building that
      was previously used as the operations center for the former Citizens Bank that
      was acquired in 2001. These sales resulted in a net gain of $419,000. Also
      during 2007, the Company sold $202,000 in loans at a net gain of $5,000.
      Offsetting a portion of these gains were losses of $80,000 from the sale of
      $3.4
      million in mortgage-backed securities and $9,000 from the sale of various
      parcels of foreclosed properties. In 2007, an officer of the Company passed
      away, resulting in net life insurance proceeds of $112,000 that were paid to
      the
      Company.





The
      2008
      nine-month period included a $230,000, or 11.3%, increase in fee income on
      deposit accounts and a $19,000, or 12.8%, increase in dividends on Federal
      Home
      Loan Bank stock. An increase in the number of demand deposit customers
      contributed to the improvement in deposit fee income, while an increased number
      of shares of FHLB stock resulting from higher borrowing balances contributed
      to
      the increase in dividends on FHLB stock.





*Noninterest
      expense.* Noninterest
      expense increased by $1.3 million, or 9.5%, to $14.7 million for the nine months
      ended September 30, 2008, compared to $13.4 million for the nine months ended
      September 30, 2007. This resulted from a $498,000, or 7.0%, increase in
      compensation and benefits, a $12,000, or 0.6%, increase in occupancy and
      equipment expense, a $236,000, or 58.6%, increase in professional services,
      and
      a $258,000, or 8.2%, increase in other noninterest expenses. Management hired
      several experienced lenders and an experienced credit officer during 2007 which
      contributed to the increase in compensation and benefits. However, we expect
      that the additional loan growth associated with these new positions will
      generate revenues to offset the additional compensation expense in 2008. The
      Company also opened its 15th full-service office in Rock Hill, South Carolina,
      during the first quarter 2008. As a result, office occupancy and equipment
      expense is expected to continue to increase in 2008. However, this increase
      has
      been tempered by the consolidation of the Company’s three loan production
      offices into existing branch facilities. The increase in professional services
      was primarily associated with higher audit-related costs, consulting fees and
      legal services. Management expects that these expenses will decrease for the
      remainder of 2008. Other noninterest expenses increased as a result of higher
      expenses related to data processing and technology, deposit operations, and
      loan
      collection and administration. A portion of the increase was related to the
      opening of a new office during the first quarter of 2008.





18


In
      addition, the Company experienced increases of $306,000 for impairment of
      securities and $220,000 in restructuring expense. Effective September 30, 2008,
      management determined that there was a $468,000 other-than-temporary impairment
      charge on a $1.0 million trust preferred collateralized debt obligation. This
      investment is discussed above in the section “Other-Than-Temporary Impairment of
      Securities”. Effective June 30, 2007, management evaluated the Company’s
      investment portfolio and determined that a $162,000 impairment existed on a
      $305,000 equity investment that was considered to be other-than-temporary,
      resulting in a $162,000 charge to earnings. The $220,000 restructuring expense
      was attributable to severance payments made to various employees whose positions
      were eliminated during the first quarter of 2008. No additional expenses are
      expected in conjunction with the reorganization.





These
      increases in noninterest expense were partly offset by a $175,000 decrease
      in
      the fair value adjustment on deferred compensation and an $81,000, or 16.8%,
      decrease in the amortization expense of intangible assets. The decrease in
      the
      fair value adjustment on deferred compensation during the comparable quarters
      was directly offset by a corresponding decrease to noninterest income, resulting
      in no net impact to the Company. The amortization of intangible assets is
      expected to continue to decrease as the amount of the core deposit intangible
      decreases.





*Income
      taxes.* Income
      taxes amounted to $647,000, or 19.6% of taxable income, for the nine months
      ended September 30, 2008, as compared to $1.5 million, or 25.9% of taxable
      income, for the nine months ended September 30, 2007. The decrease in the
      effective tax rate during the comparable periods was primarily due to a $2.6
      million decrease in income before taxes. In addition, tax equivalent adjustments
      increased from 26.0% of net income for the nine-month period ended September
      30,
      2007, to 43.7% of net income for the nine months ended September 30, 2008.
      This
      nontaxable income was primarily generated from interest earned on bank-qualified
      municipal securities and loans. The Company invests in tax-advantaged sources
      of
      income to reduce its overall tax burden. However, as the Company continues
      to
      increase the amount of income derived from interest income on loans and fee
      income on loans and deposits, the effective tax rate is expected to increase.





**Liquidity,
      Market Risk, and Capital Resources**





The
      objectives of the Company’s liquidity management policy include providing
      adequate funds to meet the cash needs of both borrowers and depositors, to
      provide for the on-going operations of the Company, and to capitalize on
      opportunities for expansion. Liquidity management addresses the Company’s
      ability to meet deposit withdrawals on demand or at contractual maturity, to
      repay borrowings as they mature, and to fund new loans and investments as
      opportunities arise. The primary sources of internally generated funds are
      principal and interest payments on loans receivable, increases in local
      deposits, cash flows generated from operations, and cash flows generated by
      investments. If the Company requires funds beyond its internal funding
      capabilities, it may rely upon external sources of funds such as brokered
      deposits, repurchase agreements, and advances. The Company has $77.7 million
      available to draw from its line of credit with the FHLB. The FHLB functions
      as a
      central reserve bank providing credit for member financial institutions. As
      a
      member of the FHLB, we are required to own capital stock in the FHLB and we
      are
      authorized to apply for advances on the security of such stock and certain
      of
      our mortgage loans and other assets (principally securities that are obligations
      of, or guaranteed by, U.S. Government Agencies) provided certain
      creditworthiness standards have been met. Advances are made pursuant to several
      different credit programs. Each credit program has its own interest rate and
      range of maturities. Depending on the program, limitations on the amount of
      advances are based on the financial condition of the member institution and
      the
      adequacy of collateral pledged to secure the credit. The Company also has $11.8
      million available from a $20.0 million unsecured federal funds accommodation
      with Silverton Bank (“Silverton”). Silverton is the Company’s primary
      correspondent bank. The federal funds accommodation is for a term of 12 months
      and is used for the purpose of providing daily liquidity as needed by the
      Company. Outstanding advances made under this accommodation are generally repaid
      on a daily basis at a rate determined by Silverton based on their marginal
      cost
      of funds. Advances are limited to not more than 14 days in any calendar month.
      Interest on any advances made over the established line or beyond the 14-day
      limit will be at a higher rate. The Company may also solicit brokered deposits
      for providing funds for asset growth. As of September 30, 2008, the Company
      had
      outstanding brokered deposits of $12.4 million, or 2.1% of total deposits.
      This
      balance was comprised of two time deposits in the amounts of $6.0 million and
      $6.4 million. Both deposits had maturities of less than six months and a
      weighted average cost of funds of 2.91%. The Company believes that it has
      sufficient sources of liquidity to fund the cash needs of both borrowers and
      depositors, to provide for the ongoing operations of the Company, and to
      capitalize on opportunities for expansion.





19


In
      the
      normal course of business, various commitments are outstanding that are not
      reflected in the consolidated financial statements. Commitments to extend credit
      and undisbursed advances on customer lines of credit are agreements to lend
      to a
      customer as long as there is no violation of any condition established in the
      contract. The funding of these commitments and previously approved undisbursed
      lines of credit could affect the Company's liquidity position. At September
      30,
      2008, the Company had loan commitments of $13.0 million, unused lines of credit
      of $111.7 million, and undisbursed construction loan proceeds of $3.6 million.
      The Company believes that it has adequate resources to fund loan commitments
      and
      lines of credit as they arise. The Company does not have any special purpose
      entities or other similar forms of off-balance-sheet financing.





The
      Company’s most significant form of market risk is interest rate risk, as the
      Company’s assets and liabilities are sensitive to changes in interest rates. The
      Company’s Asset / Liability Committee is responsible for monitoring its level of
      interest rate risk and ensuring compliance with Board-adopted limits. There
      were
      no changes in the Company’s asset or liability composition that could result in
      a material change in the Company’s analysis of interest rate sensitivity as
      discussed in the Company’s Annual Report on Form 10-K for the year ended
      December 31, 2007





The
      Bank
      is subject to various regulatory capital requirements administered by the
      banking regulatory agencies. As of September 30, 2008, the Bank’s capital
      exceeded all applicable regulatory requirements and was in the “well
      capitalized” category for all regulatory capital measurements. The Bank's Tier I
      capital was $66.8 million, or 8.4% of adjusted total assets. The minimum Tier
      I
      capital ratio is 4.00%. Failure to meet minimum capital requirements can result
      in certain mandatory and possibly discretionary actions by the regulators that,
      if undertaken, could have a direct material effect on the Bank’s financial
      statements. Under capital adequacy guidelines and the regulatory framework
      for
      prompt corrective action, the Bank must meet specific capital guidelines that
      involve quantitative measures of the Bank’s assets, liabilities, and certain
      off-balance-sheet items as calculated under regulatory accounting practices.
      The
      Bank’s capital amounts and classifications are subject to qualitative judgments
      by the regulators about components, risk-weightings, and other factors.





**ITEM
      3. Quantitative and Qualitative Disclosures About Market
      Risk**





The
      information required by this item is included above in Item 2, Management’s
      Discussion and Analysis of Financial Condition and Results of Operations, under
      the caption “Liquidity, Market Risk, and Capital Resources.”





**ITEM
      4. Controls and Procedures**





Under
      the
      supervision and with the participation of the Company’s management, including
      the Company’s Principal Executive Officer and Principal Financial Officer, the
      Company has evaluated the effectiveness of the design and operation of its
      disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e)
      under the Exchange Act) as of the end of the period covered by this report.
      Based upon that evaluation, the Principal Executive Officer and Principal
      Financial Officer concluded that, as of the end of the period covered by this
      report, the Company’s disclosure controls and procedures were
      effective.





There
      have been no material changes in the Company’s internal control over financial
      reporting identified during the Company’s last fiscal quarter that has
      negatively affected, or is reasonably likely to negatively affect, the Company’s
      internal control over financial reporting in a material manner.


20


**PART
      II. OTHER INFORMATION**





**Item
      1.**  **Legal
      Proceedings**





There
      are
      various claims and lawsuits in which the Bank is periodically involved
      incidental to the Company's business. In the opinion of management, no material
      loss is expected from any of such pending claims or lawsuits.




**Item
      1A. Risk Factors**





*FDIC
      Assessment Risk Factor.* The
      Federal Deposit Insurance Corporation (“FDIC”) imposes an assessment against
      financial institutions for deposit insurance. This assessment is based on the
      risk category of the institution and ranges from 5 to 43 basis points of the
      institution’s deposits. Federal law requires the FDIC to maintain a reserve
      ratio of 1.15% to 1.50% of estimated insured deposits. Recent bank failures
      have
      significantly reduced the deposit reserve ratio. As a result, the FDIC published
      a proposed rule that would restore the reserve ratio to its federally-mandated
      level. The proposed rule would raise the current deposit insurance assessment
      rates for all institutions by approximately 7 basis points beginning with the
      first quarter of 2009. There can be no assurance that the proposed rule will
      be
      implemented by the FDIC in its proposed form. However, the actions taken by
      the
      FDIC could significantly increase the Company’s noninterest expense in 2009 and
      in future years as long as the increased premiums are in place.





**Item
      2.**  **Unregistered
      Sales of Equity Securities and Use of Proceeds**





**a.**
            Not
                applicable.





**b.**
            Not
                applicable.





**c.**
            During
                the three-month period ended September 30, 2008, the Company repurchased
                7,200 shares of common stock for $57,000, at an average cost of $7.95
                per
                share, as detailed in the following
                table:





**Period**
            
            **Total**
              **Number of**
              **Shares**
              **Purchased**
            
            **Average**
              **Price Paid**
              **per Share**
            
            **Total Number of Shares**
              **Purchased as Part of**
              **Publicly Announced Plan**
            
            **Maximum Number of Shares**
              **that May Yet be Purchased**
              **Under the Publicly Announced**
              **Plan**July
            
            
            7,200
            
            $
            7.95
            
            
            9,476
            
            
            190,524August
            
            
            -
            
            
            -
            
            
            9,476
            
            
            190,524September
            
            
            -
            
            
            -
            
            
            9,476
            
            
            190,524**Total**
            
            
            **7,200**
            
            **$**
            **7.95**
            
            
            **9,476**
            
            
            **190,524**





As
      of
      September 30, 2008, the Company had repurchased a total of 3,209,211 shares,
      or
      35.4% of the original outstanding shares of common stock, at an average price
      of
      $13.06. This stock was repurchased under a series of repurchase programs that
      have been authorized by the Board of Directors over the past several years.
      The
      most recent repurchase authorization was granted by the Board of Directors
      on
      June 16, 2008, for the repurchase of up to 200,000 shares, or approximately
      2.7%
      of the Company’s then outstanding shares of common stock. These repurchases may
      be carried out through open market purchases, block trades, and negotiated
      private transactions. The stock may be repurchased on an ongoing basis and
      will
      be subject to the availability of stock, general market conditions, the trading
      price of the stock, alternative uses for capital, and the Company’s financial
      condition and/or performance. As of September 30, 2008, the Company had
      repurchased a total of 4,776 shares at an average price of $7.86 per share
      and
      had 195,224 shares remaining to be repurchased under this plan. Any repurchased
      shares will be held as treasury stock and will be available for general
      corporate purposes **.**





21


**Item
      3.**  **Defaults
      Upon Senior Securities**





Not
      applicable.





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





There
      were no meetings of stockholders during the quarter ended September 30,
      2008.





**Item
      5.**  **Other
      Information**





Not
      applicable.





**Item
      6.**  **Exhibits**





31.1
      Certification of Chief Executive Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.





31.2
      Certification of Chief Financial Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.





32.1
      Written statement of Chief Executive Officer furnished pursuant to Section
      906
      of the Sarbanes-Oxley Act of 2002.





32.2
      Written statement of Chief Financial Officer furnished pursuant to Section
      906
      of the Sarbanes-Oxley Act of 2002.





**SIGNATURES**





Pursuant
      to the requirements of the Securities Exchange Act of 1934, the Registrant
      has
      duly caused this report to be signed by the undersigned thereunto duly
      authorized.





**Citizens
                South Banking Corporation**Date:
                November 10, 2008
            
            By:
            /s/
                Kim S. PriceKim
                S. PricePresident
                and Chief Executive OfficerDate:
                November 10, 2008
            
            By:
            /s/
                Gary F. HoskinsGary
                F. HoskinsExecutive
                Vice President, Chief Financial Officer and
                Treasurer




22