UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
DC 20549


FORM 10-K




(X)
      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT OF 1934For
      the fiscal year ended December 31, 2008,or(  )
      TRANSITION REPORT PURSUANT TO SECTION 13 or 15 (d) OF THE SECURITIES
      EXCHANGE ACT OF 1934For
      the transition period from ______ to ______Commission
      file number0-23863PEOPLES
      FINANCIAL SERVICES CORP.(Exact
      name of registrant as specified in its charter)PENNSYLVANIA
                    23-2391852(State
      of incorporation)
                    (IRS
      Employer Identification No.)82
      FRANKLIN AVENUE, HALLSTEAD, PA
                    18822(Address
      of principal executive offices)
                    (Zip
      code)(570)
      879-2175(Registrant’s
      telephone number including area code)Securities
      registered pursuant to Section 12(b) of the Act:Title
      of each class
                    Name
      of each exchange on which registeredNone
                    NoneSecurities
      registered pursuant to Section 12(g) of the Act:COMMON
      STOCK ($2 Par Value)(Title
      of Class)Indicate
      by check mark if the registrant is a well-known seasoned issuer, as
      defined in Rule 405 of the Securities Act. Yes __ No XIndicate
      by check mark if the registrant is not required to file reports pursuant
      to Section 13 or Section 15(d) of the Act.  Yes___  No
      XIndicate
      by check mark whether the registrant (1) has filed all reports required to
      be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
      during the preceding 12 months or for such shorter period that the
      registrant was required to file such reports, and (2) has been subject to
      such filing requirements for the past 90 days Yes X
No__Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the
      best of registrant’s knowledge, in definitive proxy or information
      statements incorporated by reference in Part III of this Form 10-K or any
      amendment to this Form 10-K.  [X]Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer or a smaller reporting company
      (as defined in Rule 12b-2 of the Exchange Act).Large
      accelerated filer ____­
                    Accelerated
      filer X
                    Non-accelerated
      filer _____
                    Smaller
      reporting company _____(Do not check if smaller reporting company)Indicate
      by check mark whether the registrant is a shell company (as defined in
      Rule 12b-2 of the Exchange Act). Yes __ No XThe
      aggregate market value of voting stock held by non-affiliates of the
      registrant is $
      63,803,363  as of June 30,
      2008The
      aggregate dollar amount of the voting stock set forth equals the number of
      shares of the registrant’s Common Stock outstanding, reduced by the amount
      of Common stock held by executive officers, directors, and shareholders
      owning in excess of 10% of the registrant’s Common Stock, multiplied by
      the last sale price for the registrant’s Common Stock at June 30, 2008.
      The information provided shall in no way be construed as an admission that
      the officer, director, or 10% shareholder in the registrant may be deemed
      an affiliate of the registrant or that such person is the beneficial owner
      of the shares reported as being held by him and any such inference is
      hereby disclaimed. The information provided herein is included solely for
      the record keeping purpose of the Securities and Exchange
      Commission.Number
      of shares outstanding as of December 31, 2008
                    COMMON
      STOCK
                      ($2
      Par Value)
                      (Title
      of Class)
                    3,131,181
                      (Outstanding
      Shares)DOCUMENTS
      INCORPORATED BY REFERENCEPortions
      of the 2009 Proxy Statement for the Registrant are incorporated by
      reference into Part III of this
report.


1


TABLE OF
CONTENTS





PagePart
      I
            
            
            NumberItem
      1
            Business
            3-14Item
      1A
            Risk
      Factors
            14-16Item
      1B
            Unresolved
      Staff Comments
            16Item
      2
            Properties
            16Item
      3
            Legal
      Proceedings
            17Item
      4
            Submission
      of Matters to a Vote of Security Holders
            17Part
      IIItem
      5
            Market
      for Registrant's Common Equity and Related Stockholder
    Matters
            18-19Item
      6
            Selected
      Financial Data
            20Item
      7
            Management's
      Discussion and Analysis of Financial Condition and
            21-44Results
      of OperationsItem
      7A
            Quantitative
      and Qualitative Disclosures About Market Risk
            44Item
      8
            Financial
      Statements and Supplementary Data
            45Report
      of Independent Registered Public Accounting Firm
            45Consolidated
      Balance Sheets
            46Consolidated
      Statements of Income
            47Consolidated
      Statements of Stockholders' Equity
            48Consolidated
      Statements of Cash Flows
            49-50Notes
      to Consolidated Financial Statements
            51-91Item
      9
            Changes
      In and Disagreements with Accountants on Accounting and
              Financial
      Disclosure
            92Item
      9A
            Controls
      and Procedures
            92Item
      9B
            Other
      Information
            94Part
      IIIItem
      10
            Directors,
      Executive Officers and Corporate Governance
            95Item
      11
            Executive
      Compensation
            95Item
      12
            Security
      Ownership of Certain Beneficial Owners and Management
            95and
      Related Stockholder MattersItem
      13
            Certain
      Relationships and Related Transactions, and Director
      Independence
            95Item
      14
            Principal
      Accountant Fees and Services
            95Part
      IVItem
      15
            Exhibits
      and Financial Statement Schedules
            96Signatures
            97


2


PART
I





ITEM 1 BUSINESS





BRIEF HISTORY


Peoples
Financial Services Corp. (“PFSC” or the “Company”) was incorporated under the
laws of the Commonwealth of Pennsylvania on February 6, 1986, and is a one-bank
holding company head quartered in Hallstead, Pennsylvania.





The
Company is engaged primarily in commercial and retail banking services and in
businesses related to banking services through its subsidiaries, Peoples
National Bank (“PNB” or the “Bank”), Peoples Advisors, LLC (“Advisors”) and
Peoples Financial Capital Corporation.  The Bank has two wholly owned
subsidiaries, Peoples Financial Leasing, LLC and Peoples Investment Holdings,
LLC.  PNB was chartered in Hallstead, Pennsylvania in 1905 under the
name of The First National Bank of Hallstead. In 1965, the Hop Bottom National
Bank (chartered in 1910) merged with The First National Bank of Hallstead to
form Peoples National Bank of Susquehanna County. In 2001, the Bank changed its
name to Peoples National Bank.  Advisors was formed in 2006 as a
member-managed limited liability company for the purpose of providing investment
advisory services to the general public. Peoples Financial Leasing, LLC, formed
in 2007, is a subsidiary of the Bank and provides employee leasing services to
the Bank. Peoples Investment Holdings, LLC, formed in 2007, is also a subsidiary
of the Bank and its main activities are the maintenance and management of its
intangible investments and the collection and distribution of the income from
such investments or from tangible investments located outside of Delaware.
Finally, Peoples Financial Capital Corporation which was also formed in 2007 is
a subsidiary of the Company and its main activities are the maintenance and
management of its intangible investments and the collection and distribution of
the income from such investments or from tangible investments located outside of
Delaware.





OPERATING
SEGMENTS


The
Company has one reportable operating segment, Community Banking, which consists
of commercial and retail banking, and other non-reportable operating segments,
as described in Note 1 of the Notes to Consolidated Financial Statements
included on page 59 of this Report. The Segment Reporting information in Note 1
is incorporated by reference into this Item 1.





SUPERVISION AND
REGULATION


The
Company and its subsidiaries are extensively regulated under federal and state
law. Generally, these laws and regulations are intended to protect depositors,
not shareholders. The following is a summary description of certain provisions
of law that affect the regulation of bank holding companies and banks. This
discussion is qualified in its entirety by reference to applicable laws and
regulations. Changes in law and regulation may have a material effect on the
business and prospects of the Company, PNB, and Advisors.





The
Company is a bank holding company within the meaning of the Bank Holding Company
Act of 1956, as amended, and is subject to regulation, supervision, and
examination by the Federal Reserve Board (“FRB”). The Company is required to
file annual and quarterly reports with the FRB and to provide the FRB with such
additional information as the FRB may require. The FRB also conducts
examinations of the Company.





With
certain limited exceptions, the Company is required to obtain prior approval
from the FRB before acquiring direct or indirect ownership or control of more
than 5% of any voting securities or substantially all of the assets of a bank or
bank holding company, or before merging or consolidating with another bank
holding company. Additionally, with certain exceptions, any person or entity
proposing to acquire control through direct or indirect ownership of 25% or more
of any voting securities of the Company is required to give 60 days written
notice of the acquisition to the FRB, which may prohibit the transaction, and to
publish notice to the public.





The
Company’s banking subsidiary is a federally chartered national banking
association regulated by the Office of the Comptroller of the Currency (“OCC”).
The OCC may prohibit an institution over which it has supervisory authority from
engaging in activities or investments that the agency believes constitute unsafe
or unsound banking practices. Federal banking regulators have extensive
enforcement authority over the institutions they regulate to prohibit or correct
activities that violate law, regulation or a regulatory agreement or which are
deemed to constitute unsafe or unsound practices.


3




Enforcement
actions may include:


·
            the
      appointment of a conservator or receiver;·
            the
      issuance of a cease and desist order;·
            the
      termination of deposit insurance, the imposition of civil money penalties
      on the institution, its directors, officers, employees and institution
      affiliated parties;·
            the
      issuance of directives to increase capital;·
            the
      issuance of formal and informal agreements;·
            the
      removal of or restrictions on directors, officers, employees and
      institution-affiliated parties; and·
            the
      enforcement of any such mechanisms through restraining orders or any other
      court actions.





PNB is
subject to certain restrictions on extensions of credit to executive officers,
directors, principal shareholders or any related interests of such persons which
generally require that such credit extensions be made on substantially the same
terms as are available to third persons dealing with PNB and not involving more
than the normal risk of repayment. Other laws tie the maximum amount that may be
loaned to any one customer and its related interests to capital levels of the
Bank.





Limitations on Dividends and Other
Payments


The
Company’s current ability to pay dividends is largely dependent upon the receipt
of dividends from its banking subsidiary, PNB. Both federal and state laws
impose restrictions on the ability of the Company to pay dividends. The FRB has
issued a policy statement that provides that, as a general matter, insured banks
and bank holding companies may pay dividends only out of prior operating
earnings. Under the National Bank Act, a national bank, such as PNB, may pay
dividends only out of the current year’s net profits and the net profits of the
last two years. In addition to these specific restrictions, bank regulatory
agencies, in general, also have the ability to prohibit proposed dividends by a
financial institution that would otherwise be permitted under applicable
regulations if the regulatory body determines that such distribution would
constitute an unsafe or unsound practice.





Permitted Non-Banking
Activities


Generally,
a bank holding company may not engage in any activities other than banking,
managing, or controlling its bank and other authorized subsidiaries, and
providing service to those subsidiaries. With prior approval of the FRB, the
Company may acquire more than 5% of the assets or outstanding shares of a
company engaging in non-bank activities determined by the FRB to be closely
related to the business of banking or of managing or controlling banks. The FRB
provides expedited procedures for expansion into approved categories of non-bank
activities.





Subsidiary
banks of a bank holding company are subject to certain quantitative and
qualitative restrictions:


·
            on
      extensions of credit to the bank holding company or its
      subsidiaries;·
            on
      investments in their securities; and·
            on
      the use of their securities as collateral for loans to any
      borrower.





These
regulations and restrictions may limit the Company’s ability to obtain funds
from PNB for its cash needs, including funds for the payment of dividends,
interest and operating expenses. Further, subject to certain exceptions, a bank
holding company and its subsidiaries are prohibited from engaging in certain
tie-in arrangements in connection with any extension of credit, lease or sale of
property or furnishing of services. For example, PNB may not generally require a
customer to obtain other services from itself or the Company, and may not
require that a customer promise not to obtain other services from a competitor
as a condition to an extension of credit to the customer.





Under FRB
policy, a bank holding company is expected to act as a source of financial
strength to its subsidiary banks and to make capital injections into a troubled
subsidiary bank, and the FRB may charge the bank holding company with engaging
in unsafe and unsound practices for failure to commit resources to a subsidiary
bank when required. A required capital injection may be called for at a time
when the holding company does not have the resources to provide it. In addition,
depository institutions insured by the FDIC can be held liable for any losses
incurred by, or reasonably anticipated to be incurred by, the FDIC in connection
with the default of or assistance provided to, a commonly controlled
FDIC-insured depository institution. Accordingly, in the event that any insured
subsidiary of the company causes a loss to the FDIC, other insured subsidiaries
of the company could be required to compensate the FDIC by reimbursing it for
the estimated amount of such loss. Such cross guarantee liabilities generally
are superior in priority to the obligation of the depository institutions to its
stockholders due solely to their status as stockholders and obligations to other
affiliates.


4




Pennsylvania Law


As a
Pennsylvania bank holding company, the Company is subject to various
restrictions on its activities as set forth in Pennsylvania law. This is in
addition to those restrictions set forth in federal law. Under Pennsylvania law,
a bank holding company that desires to acquire a bank or bank holding company
that has its principal place of business in Pennsylvania must obtain permission
from the Pennsylvania Department of Banking.





Interstate Banking
Legislation


The
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 were enacted
into law on September 29, 1994. The law provides that, among other things,
substantially all state law barriers to the acquisition of banks by out-of-state
bank holding companies were eliminated effective September 29, 1995. The law
also permits interstate branching by banks effective as of June 1, 1997, subject
to the ability of states to opt-out completely or to set an earlier effective
date.





FIRREA
(Financial Institution Reform, Recovery, and Enforcement Act)


FIRREA
was enacted into law in order to address the financial condition of the Federal
Savings and Loan Insurance Corporation, to restructure the regulation of the
thrift industry, and to enhance the supervisory and enforcement powers of the
federal bank and thrift regulatory agencies. As the primary federal regulator of
the Bank, the OCC is responsible for the supervision of the Bank. When dealing
with capital requirements, the OCC and FDIC have the flexibility to impose
supervisory agreements on institutions that fail to comply with regulatory
requirements. The imposition of a capital plan, termination of deposit
insurance, and removal or temporary suspension of an officer, director or other
institution-affiliated person may cause enforcement actions.





There
are three levels of civil penalties under FIRREA.


·
            The
      first tier provides for civil penalties of up to $5,000 per day for any
      violation of law or regulation.·
            The
      second tier provides for civil penalties of up to $25,000 per day if more
      than a minimal loss or a pattern is involved.·
            Finally,
      civil penalties of up to $1 million per day may be assessed for knowingly
      or recklessly causing a substantial loss to an institution or taking
      action that results in a substantial pecuniary gain or other
      benefit.





Criminal
penalties are increased to $1 million per violation and may be up to $5 million
for continuing violations or for the actual amount of gain or loss. These
penalties may be combined with prison sentences of up to five
years.





FDICIA
(Federal Deposit Insurance Corporation Improvement Act of 1991)


In
December 1991, Congress enacted FDICIA which substantially revised the bank
regulatory and funding provisions of the Federal Deposit Insurance Act and made
significant revisions to several other federal banking statutes. FDICIA provides
for, among other things:


·
            publicly
      available annual financial condition and management reports for financial
      institutions, including audits by independent
  accountants;·
            the
      establishment of uniform accounting standards by federal banking
      agencies;·
            the
      establishment of a “prompt corrective action” system of regulatory
      supervision and intervention, based on capitalization levels, with more
      scrutiny and restrictions placed on depository institutions with lower
      levels of capital;·
            additional
      grounds for the appointment of a conservator or receiver;
    and·
            restrictions
      or prohibitions on accepting brokered deposits, except for institutions
      which significantly exceed minimum capital
  requirements.





FDICIA
also provides for increased funding of the FDIC insurance funds and the
implementation of risk-based premiums.





A central
feature of FDICIA is the requirement that the federal banking agencies take
“prompt corrective action” with respect to depository institutions that do not
meet minimum capital requirements. Pursuant to FDICIA, the federal bank
regulatory authorities have adopted regulations setting forth a five-tiered
system for measuring the capital adequacy of the depository institutions that
they supervise. Under these regulations, a depository institution is classified
in one of the following capital categories:


·
            "well
      capitalized";·
            "adequately
      capitalized";·
            "under
      capitalized";·
            "significantly
      undercapitalized"; and·
            "critically
      undercapitalized".





5





PNB is
currently classified as “well capitalized.” An institution may be deemed by the
regulators to be in a capitalization category that is lower than is indicated by
its actual capital position if, among other things, it receives an
unsatisfactory examination rating with respect to asset quality, management,
earnings or liquidity.





FDICIA
generally prohibits a depository institution from making any capital
distribution (including payment of a cash dividend) or paying any management
fees to its holding company if the depository institution would thereafter be
undercapitalized. Undercapitalized depository institutions are subject to growth
limitations and are required to submit capital restoration plans. If a
depository fails to submit an acceptable plan, it is treated as if it is
“significantly undercapitalized”. Significantly undercapitalized depository
institutions may be subject to a number of other requirements and restrictions,
including orders to sell sufficient voting stock to become adequately
capitalized, requirements to reduce total assets and stop accepting deposits
from correspondent banks. Critically undercapitalized institutions are subject
to the appointment of a receiver or conservator; generally within 90 days of the
date such institution is determined to be critically under
capitalized.





FDICIA
provides the federal banking agencies with significantly expanded powers to take
enforcement action against institutions that fail to comply with capital or
other standards. Such actions may include the termination of deposit insurance
by the FDIC or the appointment of a receiver or conservator for the institution.
FDICIA also limits the circumstances under which the FDIC is permitted to
provide financial assistance to an insured institution before appointment of a
conservator or receiver.





Under
FDICIA, each federal banking agency is required to prescribe, by regulation,
non-capital safety and soundness standards for institutions under its authority.
The federal banking agencies, including the OCC, have adopted standards
covering:


·
            internal
      controls;·
            information
      systems and internal audit systems;·
            loan
      documentation;·
            credit
      underwriting;·
            interest
      rate exposure;·
            asset
      growth; and·
            compensation
      fees and benefits.





Any
institution that fails to meet these standards may be required by the agency to
develop a plan acceptable to the agency, specifying the steps that the
institutions will take to meet the standards. Failure to submit or implement
such a plan may subject the institution to regulatory sanctions. The Company, on
behalf of PNB, believes that it meets substantially all the standards that have
been adopted. FDICIA also imposed new capital standards on insured depository
institutions. Before establishing new branch offices, PNB must meet certain
minimum capital stock and surplus requirements and must obtain OCC
approval.





Risk-Based
Capital Requirements


The
federal banking regulators have adopted certain risk-based capital guidelines to
assist in the assessment of the capital adequacy of a banking organization’s
operations for both transactions reported on the balance sheet as assets and
transactions, such as letters of credit, and recourse agreements, which are
recorded as off-balance-sheet items. Under these guidelines, nominal dollar
amounts of assets and credit-equivalent amounts of off-balance-sheet items are
multiplied by one of several risk adjustment percentages, which range from 0%
for assets with low credit risk, such as certain US Treasury securities, to 100%
for assets with relatively high credit risk, such as business
loans.





A banking
organization’s risk-based capital ratios are obtained by dividing its qualifying
capital by its total risk adjusted assets. The regulators measure risk-adjusted
assets, which include off-balance-sheet items, against both total qualifying
capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and
Tier 1 capital.


·
            "Tier
      1", or core capital, includes common equity, perpetual preferred stock
      (excluding auction rate issues) and minority interest in equity accounts
      of consolidated subsidiaries, less goodwill and other intangibles, subject
      to certain exceptions.·
            "Tier
      2", or supplementary capital, includes, among other things, limited life
      preferred stock, hybrid capital instruments, mandatory convertible
      securities, qualifying subordinated debt, and the allowance for loan and
      lease losses, subject to certain limitations and less restricted
      deductions. The inclusion of elements of Tier 2 capital is subject to
      certain other requirements and limitations of the federal banking
      agencies.





6





Banks and
bank holding companies subject to the risk-based capital guidelines are required
to maintain a ratio of Tier 1 capital to risk-weighted assets of at least 4% and
a ratio of total capital to risk-weighted assets of at least 8%. The appropriate
regulatory authority may set higher capital requirements when particular
circumstances warrant. As of December 31, 2008, PFSC’s ratio of Tier 1 capital
to risk-weighted assets stood at 12.26% and its ratio of total capital to
risk-weighted assets stood at 13.10%. In addition to risk-based capital, banks
and bank holding companies are required to maintain a minimum amount of Tier 1
capital to total assets, referred to as the leverage capital ratio, of at least
4.00%. As of December 31, 2008, the Company’s leverage-capital ratio was
9.31%.





Failure
to meet applicable capital guidelines could subject a banking organization to a
variety of enforcement actions including:


·
            limitations
      on its ability to pay dividends;·
            the
      issuance by the applicable regulatory authority of a capital directive to
      increase capital, and in the case of depository institutions, the
      termination of deposit insurance by the FDIC, as well as to the measures
      described under FDICIA as applicable to under capitalized
      institutions.





In
addition, future changes in regulations or practices could further reduce the
amount of capital recognized for purposes of capital adequacy. Such a change
could affect the ability of PNB to grow and could restrict the amount of
profits, if any, available for the payment of dividends to the
Company.





Interest Rate
Risk


In August
1995 and May 1996, the federal banking agencies adopted final regulations
specifying that the agencies will include, in their evaluations of a bank’s
capital adequacy, an assessment of the bank’s interest rate risk (“IRR”)
exposure. The standards for measuring the adequacy and effectiveness of a
banking organization’s IRR management includes a measurement of Board of
Directors and senior management oversight, and a determination of whether a
banking organization’s procedures for comprehensive risk management are
appropriate to the circumstances of the  specific banking
organization. PNB has internal IRR models that are used to measure and monitor
IRR. In addition, an outside source also assesses IRR using its model on a
quarterly basis. Additionally, the regulatory agencies have been assessing IRR
on an informal basis for several years. For these reasons, the Company does not
expect the IRR evaluation in the agencies’ capital guidelines to result in
significant changes in capital requirements for PNB.





FDIC Insurance
Assessments


As a FDIC
member institution, PNB’s deposits are insured to a maximum of $250,000 per
depositor through the Bank Insurance Fund (“BIF”) that is administered by the
FDIC and each institution is required to pay semi-annual deposit insurance
premium assessments to the FDIC. Prior to 1997, only thrift institutions were
subject to assessments to raise funds to pay the financing corporate bonds. On
September 30, 1996, as part of the Omnibus Budget Act, Congress enacted the
Deposit Insurance Funds Act of 1996, which recapitalized the Savings Association
Insurance Fund (“SAIF”) and provided that BIF deposits would be subject to 1/5
of the assessment to which SAIF deposits are subject for FICO bond payments
through 1999. Beginning in 2000, BIF deposits and SAIF deposits were subject to
the same assessment for FICO bonds. The FICO assessment for PNB for 2008 was
$.0112 for each $100 of BIF deposits.





The FDIC
adopted a risk-based deposit insurance assessment system that requires all
FDIC-insured institutions to pay quarterly premiums beginning in
2007.  Annual premiums range from 5 and 7 basis points of deposits for
well-capitalized banks with the highest examination ratings to 43 basis points
for undercapitalized institutions.  Through the second quarter of
2008, the Bank had been able to offset the premium with an assessment credit of
$218,000 for premiums paid prior to 1996.  The FDIC assessment for PNB
for 2008 was $.05799 for each $100 of BIF deposits.  FDIC insurance and
assessments increased in 2008 by $76,000 due to the additional risk-based
premiums assessed to the Company.




The
Company anticipates a significant increase in the cost of federal deposit
insurance from current levels of five to seven basis points.  The FDIC
has recently proposed to increase the assessment rate for the most highly rated
institutions to between 12 and 14 basis points for the first quarter of 2009 and
to between 10 and 14 basis points thereafter. Assessment rates could be further
increased if an institution's FHLB advances exceed 15% of deposits. The FDIC has
also established a program under which it fully guarantees all non-interest
bearing transaction accounts and senior unsecured debt of a bank or its holding
company. The Bank elected to opt out of the debt guarantee program but opted
into the deposit guarantee program and will be assessed ten basis points for
non-interest bearing transaction account balances in excess of $250,000. This
additional premium is not expected to be significant.  The FDIC has further
proposed to collect a special assessment of 20 basis points based on insured
deposits as of June 30, 2009.  This special assessment will be payable on
September 30, 2009.


7


Community Reinvestment
Act


The
Community Reinvestment Act of 1977, (“CRA”) is designed to create a system for
bank regulatory agencies to evaluate a depository institution’s record in
meeting the credit needs of its community. Until May 1995, a depository
institution was evaluated for CRA compliance based on twelve assessment
factors.





The CRA
regulations were completely revised as of July 1, 1995, (the revised CRA
regulation) to establish new performance-based standards for use in examining
for compliance.





The Bank
had its last CRA compliance examination in 2008 and received a “satisfactory”
rating.





Concentration


Payment
risk is a function of the economic climate in which the Bank’s lending
activities are conducted. Economic downturns in the economy generally or in a
particular sector could cause cash flow problems for customers and make loan
payments more difficult. The Bank attempts to minimize this risk by avoiding
loan concentrations to a single customer or to a small group of customers whose
loss would have a materially adverse effect on the financial condition of the
Bank.





Monetary Policy


The
earnings of a bank holding company are affected by the policies of regulatory
authorities, including the FRB, in connection with the FRB’s regulation of the
money supply. Various methods employed by the FRB are:


·
            open
      market operations in United States Government
  securities;·
            changes
      in the discount rate on member bank borrowings; and·
            changes
      in reserve requirements against member bank
  deposits.





These
methods are used in varying combinations to influence overall growth and
distribution of bank loans, investments, and deposits, and their use may also
affect interest rates charged on loans or paid on deposits. The monetary
policies of the FRB have had a significant effect on the operating results of
commercial banks in the past and are expected to do so in the
future.





RECENT
LEGISLATION


USA Patriot Act of
2001


In
October 2001, the USA Patriot Act of 2001 was enacted in response to the
terrorist attacks in New York, Pennsylvania and Washington D.C., which occurred
on September 11, 2001. The Patriot Act is intended to strengthen U.S. law
enforcement’s and the intelligence communities’ abilities to work cohesively to
combat terrorism on a variety of fronts. The potential impact of the Patriot Act
on financial institutions of all kinds is significant and wide ranging. The
Patriot Act contains sweeping anti-money laundering and financial transparency
laws and imposes various regulations, including standards for verifying client
identification at account opening, and rules to promote cooperation among
financial institutions, regulators and law enforcement entities in identifying
parties that may be involved in terrorism or money laundering.





Financial Services Modernization
Legislation


In
November 1999, the Gramm-Leach-Bliley Act of 1999, or the GLB, was enacted. The
GLB repeals provisions of the Glass-Steagall Act which restricted the
affiliation of Federal Reserve member banks with firms “engaged principally” in
specified securities activities, and which restricted officer, director or
employee interlocks between a member bank and any company or person “primarily
engaged” in specified securities activities.





The
GLB also permits national banks to engage in expanded activities through the
formation of financial subsidiaries. A national bank may have a subsidiary
engaged in any activity authorized for national banks directly or any financial
activity, except for insurance underwriting, insurance investments, real estate
investment or development, or merchant banking, which may only be conducted
through a subsidiary of a financial holding company. Financial activities
include all activities permitted under new sections of the Bank Holding Company
Act or permitted by regulation.





To the
extent that the GLB permits banks, securities firms and insurance companies to
affiliate, the financial services industry may experience further consolidation.
The GLB is intended to grant to community banks certain powers as a matter of
right that larger institutions have accumulated on an ad hoc basis and which
unitary savings and loan holding companies already possess. Nevertheless, the
GLB may have the result of increasing the amount of competition that the
Registrant faces from larger institutions and other types of companies offering
financial products, many of which may have substantially more financial
resources than the Registrant has.


8


Sarbanes-Oxley Act of
2002


On July
30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002, or the
SOA. The stated goals of the SOA are to increase corporate responsibility, to
provide for enhanced penalties for accounting and auditing improprieties at
publicly traded companies and to protect investors by improving the accuracy and
reliability of corporate disclosures pursuant to the securities
laws.





The SOA
is the most far-reaching U.S. securities legislation enacted in some time. The
SOA generally applies to all companies, both U.S. and non-U.S., that file or are
required to file periodic reports with the Securities and Exchange Commission
(the “SEC”) under the Securities Exchange Act of 1934, or the Exchange
Act.  The legislation includes provisions, among other things,
governing the services that can be provided by a public company’s independent
auditors and the procedures for approving such services, requiring the chief
executive officer and principal accounting officer to certify certain matters
relating to the company’s periodic filings under the Exchange Act, requiring
expedited filings of reports by insiders of their securities transactions and
containing other provisions relating to insider conflicts of interest,
increasing disclosure requirements relating to critical financial accounting
policies and their application, increasing penalties for securities law
violations, and creating a new public accounting oversight board, a regulatory
body subject to SEC jurisdiction with broad powers to set auditing, quality
control and ethics standards for accounting firms.





The
Company does not believe that the application of these rules to the Company have
a material effect on its results of operations.





Regulation W


Transactions
between a bank and its “affiliates” are quantitatively and qualitatively
restricted under the Federal Reserve Act. The Federal Deposit Insurance Act
applies Sections 23A and 23B to insured nonmember banks in the same manner and
to the same extent as if they were members of the Federal Reserve System. The
Federal Reserve Board has also recently issued Regulation W, which co-defies
prior regulations under Sections 23A and 23B of the Federal Reserve Act and
interpretative guidance with respect to affiliate transactions. Regulation W
incorporates the exemption from the affiliate transaction rules but expands the
exemption to cover the purchase of any type of loan or extension of credit from
an affiliate. Affiliates of a bank include, among other entities, the bank’s
holding company and companies that are under common control with the bank. The
Company is considered to be an affiliate of the Bank. In general, subject to
certain specified exemptions, a bank or its subsidiaries are limited in their
ability to engage in “covered transactions” with affiliates:


·
            to
      an amount equal to 10% of the bank's capital and surplus, in the case of
      covered transactions with any one affiliate; and·
            to
      an amount equal to 20% of the bank's capital and surplus, in the case of
      covered transactions with all
affiliates.





In
addition, a bank and its subsidiaries may engage in covered transactions and
other specified transactions only on terms and under circumstances that are
substantially the same, or at least as favorable to the bank or its subsidiary,
as those prevailing at the time for comparable transactions with nonaffiliated
companies. A “covered transaction” includes:


·
            a
      loan or extension of credit to an affiliate;·
            a
      purchase of, or an investment in, securities issued by an
      affiliate;·
            a
      purchase of assets from an affiliate, with some
  exceptions;·
            the
      acceptance of securities issued by an affiliate as collateral for a loan
      or extension of credit to any party; and·
            the
      issuance of a guarantee, acceptance or letter of credit on behalf of an
      affiliate.





Regulation
W generally excludes all non-bank and non-savings association subsidiaries of
banks from treatment as affiliates, except to the extent that the Federal
Reserve Board decides to treat these subsidiaries as affiliates.





Concurrently
with the adoption of Regulation W, the Federal Reserve Board has proposed a
regulation which would further limit the amount of loans that could be purchased
by a bank from an affiliate to not more than 100% of the bank’s capital and
surplus.





Legislation and Regulatory
Changes


From time
to time, legislation is enacted that affects the cost of doing business or
limits the activities of a financial institution. We cannot predict the
likelihood of any major changes or the impact those changes may have on the
Company.


9


MARKET AREAS


The PNB
market areas are in the northeastern part of Pennsylvania with the primary focus
being Susquehanna and Wyoming Counties. With the addition of an office in
Conklin, Broome County, New York in 2003, and offices in the Village of Deposit
and Town of Chenango, both in Broome County, New York, in 2005, Broome County is
part of the Bank’s market area, particularly the Southern Tier that encompasses
the towns of Conklin, Kirkwood, Windsor, and Deposit. The Bank’s market area was
expanded further in 2008 with the addition of the Glenburn Township office. This
gave PNB its first physical presence in Lackawanna County, serving the northern
end of the county including the Clarks Summit area. In addition, parts of Wayne
and Bradford Counties in Pennsylvania that border Susquehanna and Wyoming
Counties are also considered part of the PNB market area.





The PNB
market area is situated between:


·
            the
      city of Binghamton, Broome County, New York, located to the
      north;·
            the
      city of Scranton, Lackawanna County, Pennsylvania, to the south;
      and·
            Wilkes-Barre,
      Luzerne County, Pennsylvania, to the
southwest.





Susquehanna
County could best be described as a bedroom county with a high percentage of its
residents commuting to work in Broome County, New York, or to the Scranton,
Pennsylvania, area. The southern part of Susquehanna County tends to gravitate
south for both employment and shopping, while the northern part of the county
goes north to Broome County, New York. The western part of Susquehanna County
gravitates south and west to and through Wyoming County. Wyoming County is home
to a Proctor & Gamble manufacturing facility. This is an economic stimulus
to Wyoming County and the surrounding areas.





The
majority of our offices are located in counties that would be considered
sparsely populated, as they are made up of many small towns and villages. The
latest population figures show Susquehanna County at approximately 42,000 and
Wyoming County at approximately 28,000 residents. Neither county is experiencing
growth. Broome County has approximately 196,000 residents and continues to
experience a population decline. The economy of Broome County has lost many
manufacturing jobs in the past twenty to twenty-five years. This trend
continues. Fortunately, the new employment centers are in the Town of Conklin
and the neighboring Town of Kirkwood. Both towns border Susquehanna County,
Pennsylvania. Lackawanna County has approximately 210,000 residents. Interstate
81 runs north and south through the eastern half of Susquehanna County and has
brought an influx of people from New Jersey and the Philadelphia area. These
people have purchased homes and land to build homes that are used as
vacation/recreation retreats and, quite often, become retirement
homes.





BUSINESS


Lending
Activities


PNB
provides a full range of retail and commercial banking services designed to meet
the borrowing and depository needs of small and medium sized businesses and
consumers in its market areas. A significant amount of PNB’s loans are to
customers located within its service areas. PNB has no foreign loans or highly
leveraged transaction loans, as defined by the FRB. A majority of the loans in
PNB’s portfolio have been originated by PNB. Policies adopted by the Board of
Directors are the basis by which PNB conducts its lending activities. These loan
policies grant individual lending officers authority to make secured and
unsecured loans in specific dollar amounts. Larger loans must be approved by
senior officers or by the Board of Directors. PNB’s management information
systems and loan review policies are designed to monitor lending to ensure
adherence to PNB’s loan policies.





The
commercial loans offered by PNB include:


·
            commercial
      real estate loans;·
            working
      capital;·
            equipment
      and other commercial loans;·
            construction
      loans;·
            SBA
      guaranteed loans; and·
            agricultural
      loans.





PNB’s
commercial real estate loans are used primarily to provide financing for retail
operations, manufacturing operations, farming operations, multi-family housing
units, and churches. Commercial real estate secured loans are generally written
for a term of 15 years or less or amortized over a longer period with balloon
payments at shorter intervals. Personal guarantees are obtained on nearly all
commercial loans. Credit analysis, loan review, and an effective collections
process are also used to minimize any potential losses. PNB employs five
full-time commercial lending officers. These five people are augmented by branch
managers who are authorized to make smaller, less complex, commercial
loans.


10


Payment
risk is a function of the economic climate in which PNB’s lending activities are
conducted; economic downturns in the economy generally or in a particular sector
could cause cash flow problems for customers and make loan payments more
difficult. PNB attempts to minimize this risk by avoiding concentrations of
credit to single borrowers or borrowers in a particular industry. Interest rate
risk would occur if PNB were to make loans at fixed rates in an environment in
which rates were rising thereby preventing PNB from making loans at the higher
prevailing rates. PNB attempts to mitigate this risk by making adjustable rate
commercial loans and, when extending fixed rate commercial loans, fixing loan
maturities at five years or less. Finally, collateral risk can occur if PNB’s
position in collateral taken as security for loan repayment is not adequately
secured. PNB attempts to minimize collateral risk by avoiding loan
concentrations to particular borrowers, by perfecting liens on collateral and by
obtaining appraisals on property prior to extending loans.





Consumer
loans offered by PNB include:


·
            residential
      real estate loans;·
            automobile
      loans;·
            manufactured
      housing loans;·
            personal
      installment loans secured and unsecured for almost any
      purpose;·
            student
      loans; and·
            home
      equity loans (fixed-rate term and open ended revolving lines of
      credit).





PNB
offers credit cards as an agent bank through another correspondent
bank.





Risks
applicable to consumer lending are similar to those applicable to commercial
lending. PNB attempts to mitigate payment risk in consumer lending by limiting
consumer lending products to a term of five years or less. To the extent that
PNB extends unsecured consumer loans, there is greater collateral risk; however,
credit checks and borrower history are obtained in all consumer loan
transactions.





Residential
mortgage products include adjustable-rate as well as conventional fixed-rate
loans. Terms vary from 1, 5, and 10-year adjustable rate loans to 5, 10, 15, 20,
and 30-year fully amortized fixed rate loans. Bi-weekly payment plans are also
available. Personal secured and unsecured revolving lines of credit with
variable interest rates and principal amounts ranging from $1,000 to $10,000 are
offered to credit-worthy customers. The largest segment of PNB’s installment
loan portfolio is fixed-rate loans. Most are secured either by automobiles,
motorcycles, snowmobiles, boats, other personal property, or by liens filed
against real estate. These loans are generally available in terms of up to 15
years with automobile loans having maturities of up to 60 months and real estate
loans having maturities up to 15 years. Loans secured by other collateral
usually require a maturity of less than 60 months. Home equity products include
both fixed-rate term products and also an open-end revolving line of credit with
a maximum loan-to-value ratio of 80% of current appraisal. A special MGIC
program now offered through the Bank, allows for loans of up to 95% of the
appreciated value for qualified applicants. Credit checks, credit scoring, and
debt-to-income ratios within preset parameters are used to qualify
borrowers.





Mortgage
loans have historically had a longer average life than commercial or consumer
loans. Accordingly, payment and interest rate risks are greater in some respects
with mortgage loans than with commercial or consumer lending. Deposits, which
are used as the primary source to fund mortgage lending, tend to be of shorter
duration than the average maturities on residential mortgage loans and are more
susceptible to interest rate changes. Historical records indicate that our
mortgage loans, no matter what maturity, have an average life of less than seven
years. In 2003, the Bank started selling mortgages in the secondary market.
Mortgages are also written with adjustable rates. Mortgage lending is also
subject to economic downturns, in that increases in unemployment could adversely
affect the ability of borrowers to repay mortgage loans and decreases in
property values could affect the value of the real estate serving as collateral
for the loan.





Loan
growth remained steady in 2008 when compared to 2007 and
2006.  Industry standard debt-to-income ratios and credit checks are
used to qualify borrowers on all consumer loans. Managers, assistant managers,
and customer service officers have retail lending authorities at each of the
full-service branch office locations. PNB has centralized loan administration at
its operations/administrative offices where mortgage underwriting and loan
review and analysis take place.


11


Loan Approval


Individual
loan authorities are established by PNB’s Board of Directors upon recommendation
by the chief credit officer. In establishing an individual’s loan authority, the
experience of the lender is taken into consideration, as well as the type of
lending in which the individual is involved. The President of PNB, along with
members of senior management (loan committee), has the authority to approve new
loans over $250,000 up to $2,000,000 and all aggregate loans $325,000 to
$2,500,000 following an analysis and review by credit analysts and commercial
lender.  The full Board of Directors reviews on a monthly basis, all
loans approved by individual lenders and the officers’ loan committee. All loan
requests which are either complex in nature or exceed $2,000,000 new or
$2,500,000 aggregate must be analyzed and reviewed by the loan committee and
presented with a recommendation to the full Board of Directors for approval or
denial.





PNB
generally requires that loans secured by first mortgages or real estate have
loan-to-value ratios of less than 80% for loans secured by raw land or improved
property. In addition, in some instances for qualified borrowers, private
mortgage insurance is available for purchase that allows loan-to-value ratios to
go as high as 100%. PNB also participates in a guaranteed mortgage insurance
program. This allows PNB to make loans on real estate up to 100% of the value of
the property. Adjustable rate mortgage products, as well as conventional
fixed-rate products, are also available at PNB.





Deposit
Activities


PNB
offers a full range of deposit and banking services including commercial
checking products, cash management services, retirement accounts such as
Individual Retirement Accounts (“IRA”), retail deposit services such as
certificates of deposit, money market accounts, savings accounts, a variety of
ancillary checking account products such as automated teller machines (“ATM’s”),
point of sale (“POS”), automated clearing house (“ACH”) originations, remote
deposit capture (“RDC”) as well as other miscellaneous services.





These
miscellaneous services would include:


·
            safe
      deposit boxes;·
            night
      depository services;·
            traveler’s
      checks;·
            merchant
      credit cards;·
            direct
      deposit of payroll and other checks;·
            U.S.
      Savings Bonds;·
            official
      bank checks; and·
            money
      orders.





The
principal sources of funds for PNB are core deposits that include demand
deposits, interest bearing transaction accounts, money market accounts, savings
deposits, and certificates of deposit. These deposits are solicited from
individuals, businesses, non-profit entities, and government authorities.
Substantially all of PNB’s deposits are from the local market areas surrounding
each of its offices.





Investment
Products


In 1999,
PNB entered into an agreement with T.H.E. Financial Services to sell investment
products. In September of 2003, T.H.E. Financial Services was acquired by
Financial Network Investment Corporation (FNIC) of Torrance,
California.  PNB signed a contract dated September 29, 2003 with
FNIC.  PNB discontinued broker-dealer services with FNIC and
contracted with Uvest Financial Services, Charlotte, North Carolina, effective
September 6, 2005.  In 2005, Peoples Financial Services Corp. formed
Peoples Advisors, LLC (“Advisors”) as a member-managed limited liability company
under the laws of the Commonwealth of Pennsylvania, to be a wholly owned
subsidiary of the Corporation, for the purpose of providing investment advisory
services to the general public.





Investment Portfolio and
Activities


PNB’s
investment portfolio has several objectives.


·
            A
      key objective is to provide a balance in PNB's asset mix of loans and
      investments consistent with its liability structure, and to assist in
      management of interest rate risk. The investments augment PNB's capital
      position in the risk-based capital formula, providing the necessary
      liquidity to meet fluctuations in credit demands of the community and also
      fluctuations in deposit levels.·
            In
      addition, the portfolio provides collateral for pledging against public
      funds, and a reasonable allowance for control of tax
      liabilities.·
            Finally,
      the investment portfolio is designed to provide income for
      PNB.


In view
of the above objectives, the portfolio is treated conservatively by management
and only securities that pass those criteria are purchased.
 12




Competition


PNB
operates in a fairly competitive environment, competing for deposits and loans
with commercial banks, thrifts, credit unions, and finance and mortgage
companies. Some of these competitors possess substantially greater financial
resources than those available to PNB. Also, certain of these institutions have
significantly higher lending limits than PNB and may provide various services
for their customers that are not presently available at
PNB.  Financial institutions generally compete on the basis of rates
and service. PNB is subject to increasing competition from credit unions,
finance companies, and mortgage companies that may not be subject to the same
regulatory restrictions and taxations as commercial banks.





PNB will
seek to remain competitive with interest rates that it charges on its loans and
offers on deposits. It also believes that its success has been, and will
continue to be, due to its emphasis on community involvement, customer services,
and relationships. With consolidation continuing in the financial industry, and
particularly in PNB’s markets, smaller profitable banks are gaining
opportunities where larger institutions exit markets that are only marginally
profitable for them.





The
financial services industry in the Company’s service area is extremely
competitive. The Company’s competitors within its service area include banks and
bank holding companies with substantially greater resources. Many competitors
have substantially higher legal lending limits.





In
addition, savings banks, savings and loan associations, credit unions, money
market and other mutual funds, mortgage companies, leasing companies, finance
companies, and other financial services companies offer products and services
similar to those offered by the Company and PNB, on competitive
terms.





Although
the Company has not done so, many bank holding companies have elected to become
financial holding companies under the Gramm-Leach-Bliley Act, which gives them a
broader range of products with which we must compete. Although the long-range
effects of this development cannot be predicted, most probably it will further
narrow the differences and intensify competition among commercial banks,
investment banks, insurance firms and other financial services
companies.





SEASONALITY


Management
does not feel that the deposits or the business of PNB in general are seasonal
in nature. The deposits may, however, vary with local and national economic
conditions but should not have a material effect on planning and policy
making.





CRITICAL ACCOUNTING
POLICIES


Disclosure
of the Company’s significant accounting policies is included in Note 1 to the
Consolidated Financial Statements. Some of these policies are particularly
sensitive requiring significant judgments, estimates and assumptions to be made
by management. Additional information is contained in Management’s Discussion
and Analysis for these issues, including the provision and allowance for loan
losses, which are located in Note 3 to the Consolidated Financial Statements;
the valuation of real estate acquired in connection with foreclosures or in
satisfaction of loans; determination of other-than-temporary impairment losses
on securities, which is located in Note 2 to the Consolidated Financial
Statements; the valuation of deferred tax assets, which is located in Note 9 to
the consolidated financial statements; and the potential impairment of
restricted stock, which is located in Note 2 to the consolidated financial
statements.





Significant
estimates are made by management in determining the allowance for loan losses.
Consideration is given to a variety of factors in establishing this estimate. In
estimating the allowance for loan losses, management considers current economic
conditions, diversification of the loan portfolio, delinquency statistics,
results of internal loan review, financial and managerial strengths of
borrowers, adequacy of collateral, if collateral dependent, or present value of
future cash flows and other relevant factors.   In estimating the
valuation of real estate acquired in connection with foreclosure or in
satisfaction of loans, management considers current economic conditions and
appraised values of collateral, if collateral dependent.  When
determining if there is other-than-temporary impairment losses on securities,
management considers (1) the length of time and the extent to which the fair
value has been less than costs (2) the financial condition and near-term
prospects of the issuer, and (3) the intent and ability of the Company to retain
its investment in the issuer for a period of time sufficient to allow for any
anticipated recovery in fair value.


13


INTERNET ADDRESS
DISCLOSURES


PNB’s
Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports
on Form 8-K and amendments to those reports can be found via a link to the SEC
Web page through our Website located at  www.peoplesnatbank.com.   This
website is available free of charge.





PNB has
posted its Code of Ethics for the chief executive officer, chief operation and
financial officer, and controller. This policy can be found at our Website
located at www.peoplesnatbank.com.
Copies are also available upon request and free of charge for Shareholders
without Web access.





STATISTICAL
DISCLOSURES


The
following statistical disclosures are included in Management’s Discussion and
Analysis, Item 7 hereof, and are incorporated by reference in this Item
1:


·
            Interest
      Rate Sensitivity Analysis;·
            Interest
      Income and Expense, Volume and Rate Analysis;·
            Investment
      Portfolio;·
            Loan
      Maturity and Interest Rate Sensitivity;·
            Loan
      Portfolio;·
            Allocation
      of Allowance for Loan Losses;·
            Deposits;
      and·
            Short-term
      Borrowings.





ITEM
1A RISK FACTORS


Changes
in interest rates could reduce our income, cash flows and asset
values.


Our
income and cash flows and the value of our assets depend to a great extent on
the difference between the interest rates we earn on interest-earning assets,
such as loans and investment securities, and the interest rates we pay on
interest-bearing liabilities such as deposits and borrowings.  These
rates are highly sensitive to many factors which are beyond our control,
including general economic conditions and policies of various governmental and
regulatory agencies and, in particular, the Board of Governors of the Federal
Reserve System.  Changes in monetary policy, including changes in
interest rates, will influence not only the interest we receive on our loans and
investment securities and the amount of interest we pay on deposits and
borrowings, but will also affect our ability to originate loans and obtain
deposits and the value of our investment portfolio.  If the rate of
interest we pay on our deposits and other borrowings increases more than the
rate of interest we earn on our loans and other investments, our net interest
income, and therefore our earnings, could be adversely affected. Our earnings
also could be adversely affected if the rates on our loans and other investments
fall more quickly than those on our deposits and other borrowings.





Economic
conditions either nationally or locally in areas in which our operations are
concentrated may adversely affect our business.


Deterioration
in local, regional, national or global economic conditions could cause us to
experience a reduction in deposits and new loans, an increase in the number of
borrowers who default on their loans and a reduction in the value of the
collateral securing their loans, all of which could adversely affect our
performance and financial condition.  Unlike larger banks that are
more geographically diversified, we provide banking and financial services
locally.  Therefore, we are particularly vulnerable to adverse local
economic conditions.





Our
financial condition and results of operations would be adversely affected if our
allowance for loan losses is not sufficient to absorb actual losses or if we are
required to increase our allowance.


Despite
our underwriting criteria, we may experience loan delinquencies and
losses.  In order to absorb losses associated with nonperforming
loans, we maintain an allowance for loan losses based on, among other things,
historical experience, an evaluation of economic conditions, and regular reviews
of delinquencies and loan portfolio quality.  Determination of the
allowance inherently involves a high degree of subjectivity and requires us to
make significant estimates of current credit risks and future trends, all of
which may undergo material changes.  At any time, there are likely to
be loans in our portfolio that will result in losses but that have not been
identified as non-performing or potential problem credits.  We cannot
be sure that we will be able to identify deteriorating credits before they
become nonperforming assets or that we will be able to limit losses on those
loans that are identified.  We may be required to increase our
allowance for loan losses for any of several reasons.  Regulators, in
reviewing our loan portfolio as part of a regulatory examination, may request
that we increase our allowance for loan losses.  Changes in economic
conditions affects borrowers, new information regarding existing loans,
identification of additional problem loans and other factors, both within and
outside of our control, may require an increase in our allowance.  In
addition, if charge-offs in future periods exceed our allowance for loan losses,
we will need additional increases in our allowance for loan
losses.  Any increase in our allowance for loan losses will result in
a decrease in our net income and, possibly, our capital, and may materially
affect our results of operations in the period in which the allowance is
increased.


14


Competition
may decrease our growth or profits.


We face
substantial competition in all phases of our operations from a variety of
different competitors, including commercial banks, credit unions, consumer
finance companies, insurance companies and money market funds.  There
is very strong competition among financial services providers in our principal
service area.  Our competitors may have greater resources, higher
lending limits or larger branch systems than we do.  Accordingly, they
may be able to offer a broader range of products and services as well as better
pricing for those products and services than we can.  In addition,
some of the financial services organizations with which we compete are not
subject to the same degree of regulation as is imposed on federally insured
financial institutions.  As a result, those non-bank competitors may
be able to access funding and provide various services more easily or at less
cost than we can, adversely affecting our ability to compete
effectively.





We
may be adversely affected by government regulation.


The
banking industry is heavily regulated.  Banking regulations are
primarily intended to protect the federal deposit insurance funds and
depositors, not shareholders.  Changes in the laws, regulations, and
regulatory practices affecting the banking industry may increase our cost of
doing business or otherwise adversely affect us and create competitive
advantages for others.  Regulations affecting banks and financial
services companies undergo continuous change, and we cannot predict the ultimate
effect of these changes, which could have a material adverse effect on our
profitability or financial condition.





We
rely on our management and other key personnel, and the loss of any of them may
adversely affect our operations.


We are,
and will continue to be, dependent upon the services of our management
team.  The unexpected loss of services of any key management personnel
could have an adverse effect on our business and financial condition because of
their skills, knowledge of our market, years of industry experience and the
difficulty of promptly finding qualified replacement personnel.





Environmental
liability associated with lending activities could result in
losses.


In the
course of our business, we may foreclose on and take title to properties
securing our loans.  If hazardous substances were discovered on any of
these properties, we could be liable to governmental entities or third parties
for the costs of remediation of the hazard, as well as for personal injury and
property damage.  Many environmental laws can impose liability
regardless of whether we knew of, or were responsible for, the
contamination.  In addition, if we arrange for the disposal of
hazardous or toxic substances at another site, we may be liable for the costs of
cleaning up and removing those substances from the site even if we neither own
nor operate the disposal site.  Environmental laws may require us to
incur substantial expenses and may materially limit use of properties we acquire
through foreclosure, reduce their value or limit our ability to sell them in the
event of a default on the loans they secure.  In addition, future laws
or more stringent interpretations or enforcement policies with respect to
existing laws may increase our exposure to environmental liability.





Failure
to implement new technologies in our operations may adversely affect our growth
or profits.


The
market for financial services, including banking services and consumer finance
services, is increasingly affected by advances in technology, including
developments in telecommunications, data processing, computers, automation,
Internet-based banking and telebanking.  Our ability to compete
successfully in our markets may depend on the extent to which we are able to
exploit such technological changes.  However, we can provide no
assurance that we will be able to properly or timely anticipate or implement
such technologies or properly train our staff to use such
technologies.  Any failure to adapt to new technologies could
adversely affect our business, financial condition or operating
results.





An
investment in our common stock is not an insured deposit.


Our
common stock is not a bank deposit and, therefore, is not insured against loss
by the Federal Deposit Insurance Corporation, commonly referred to as the FDIC,
or any other deposit insurance fund or by any other public or private
entity.  Investment in our common stock is subject to the same market
forces that affect the price of common stock in any company.


15


Our
legal lending limits are relatively low and restrict our ability to compete for
larger customers.


At
December 31, 2008, our lending limit per borrower was approximately $6,100,000
or approximately 15% of our unimpaired capital. Accordingly, the size of
loans that we can offer to potential borrowers (without participation by other
lenders) is less than the size of loans that many of our competitors with larger
capitalization are able to offer.  Our legal lending limit also
impacts the efficiency of our lending operation because it tends to lower our
average loan size, which means we have to generate a higher number of
transactions to achieve the same portfolio volume.  We may engage in
loan participations with other banks for loans in excess of our legal lending
limits.  However, there can be no assurance that such participations
will be available at all or on terms which are favorable to us and our
customers.





Market
conditions may adversely affect our fee based investment business.


The
Company receives fee based revenues from commissions from the sale of securities
and investment advisory fees.  In the event of decreased stock market
activity, the volume of trading facilitated by Uvest Financial Services will in
all likelihood decrease resulting in decreased commission revenue on purchases
and sales of securities.  In addition, investment advisory fees, which
are generally based on a percentage of the total value of an investment
portfolio, will decrease in the event of decreases in the values of the
investment portfolios, for example, as a result of overall market
declines.





ITEM
1B UNRESOLVED STAFF COMMENTS





NONE.





ITEM
2 PROPERTIES





PNB has
four full-service banking offices in Susquehanna County that are located
in:


·
            Borough
      of Susquehanna Depot;·
            Hallstead
      Plaza, Great Bend Township;·
            Borough
      of Hop Bottom; and·
            Montrose,
      Bridgewater Township.





PNB’s
presence in Wyoming County, Pennsylvania had been limited to a de novo branch in
Nicholson, which opened in 1992, until the purchase of the two Mellon bank
offices in 1997. The Wyoming County locations are:


·
            Borough
      of Nicholson;·
            Meshoppen
      Township; and·
            Tunkhannock
      Borough.





PNB has
entered into Lackawanna in 2008 with a de novo branch in
Glenburn.  The Lackawanna County location is:


·
            Glenburn
      Township.





The
administrative/operations office of the Company and PNB is located at 82
Franklin Avenue, Hallstead, Pennsylvania. The following departments are located
at that office:


·
            commercial,
      mortgage and consumer lending operations;·
            executive
      offices;·
            marketing
      department;·
            human
      resources department;·
            deposit
      account support services;·
            data
      processing services; and·
            corporate
      accounting.





16


PNB began
expanding its branch locations into New York in 2002. The latest updates on
these expansions are:


·
            The
      Bank had an office located in the Price Chopper Super Market in Norwich,
      Chenango County, New York. This office was purchased from Mohawk Community
      Bank, Amsterdam, New York, in March of 2002. A decision was made to close
      this office effective March 31, 2003, because of its distance from
      Hallstead, high lease payments, and lack of growth opportunity for our
      Bank in that area.·
            Subsequently,
      real estate was purchased in Conklin, New York, approximately 10 miles
      from Hallstead. Regulators approved permission to establish an office at
      that site and the official opening date was March 17, 2003.  The
      office is located at 1026 Conklin Road and is approximately ten miles from
      the Administrative Office of PNB.·
            Also,
      on December 12, 2002, property was purchased at 108 Second Street, Town of
      Sanford, Village of Deposit, Broome County, New York. Regulatory approval
      was received to establish this second New York State office, and the
      official opening date of this office, which is located approximately 25
      miles from the Administrative Office, was April 18,
  2005.·
            The
      application was approved for the third New York State office located on
      Front Street in the Town of Chenango, Broome County.  This
      office, which was officially opened on June 6, 2005, is approximately 20
      miles from the Administrative
Office.





All
offices are owned in fee title by PNB with the exception of the Hallstead Plaza,
Meshoppen and Town of Chenango offices. The Hallstead Plaza and Meshoppen
offices are subject to ground leases; and the Front Street office is subject to
a building lease. Each lease is either long-term expiring in September 2028 or
includes renewal options. Current lease payments range from $3,296 to $38,496
annually. The leases provide that the Bank pay property taxes, insurance, and
maintenance costs. Eleven of the twelve offices provide drive-up banking
services and ten offices have 24-hour ATM services.





ITEM
3 LEGAL PROCEEDINGS





The
Company is subject to lawsuits and claims arising out of its
business.  In the opinion of the Company’s management, after review
and consultation with counsel, any proceedings that may arise should not result
in judgments, which, in the aggregate, would have a material adverse effect on
the Company’s consolidated financial statements.






ITEM
4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS




NONE.


17


PART II





ITEM 5 MARKET FOR REGISTRANT'S COMMON
EQUITY AND RELATED STOCKHOLDER MATTERS





The
Company’s Common Stock is not listed on an exchange or quoted on the National
Association of Securities Dealers, Inc. Automated Quotation system (NASDAQ). The
Company’s common stock is traded sporadically in the over-the-counter market
and, accordingly, there is no established public trading market at this time.
The Company’s stock is listed on the OTC Bulletin Board under the symbol PFIS.
The cusip number is 711040-10-5. The investment firms of Boenning &
Scattergood, Inc. from West Conshohocken, Pennsylvania, and Ryan Beck from
Livingston, New Jersey, make a limited market in the Company’s common stock. The
Company, and previously the Bank, have continuously paid dividends for more than
100 years and it is the intention to pay dividends in the future. However,
future dividends must necessarily depend upon earnings, financial condition,
appropriate legal restrictions, and other factors at the time that the Board of
Directors considers dividend payments. As of December 31, 2008, there were
33,549 outstanding options to purchase the Company’s common stock. See Note 8 of
the Consolidated Financial Statements for more information. Book value of common
stock at December 31, 2008, was $12.69 and on December 31, 2007, it was $13.62.
As of December 31, 2008, the Company had approximately 1,093 shareholders of
record. At such date, 3,131,181 shares of Common Stock were
outstanding.





The
following table reflects high and low bid prices for shares of the Company’s
Common Stock to the extent such information is available, and the dividends
declared with respect thereto during the preceding two years.





COMPANY
STOCK


2008
                                                          
                                                          
                                                          2007Price
      Range
                                                          
                                                          
                                                          Dividends
                                                          
                                                          
                                                          Price
      Range
                                                          
                                                          
                                                          DividendsLow
                                                          
                                                          
                                                          High
                                                          
                                                          
                                                          Declared
                                                          
                                                          
                                                          Low
                                                          
                                                          
                                                          High
                                                          
                                                          
                                                          DeclaredFirst
      Quarter
                                                          
                                                          $
                                                          22.00
                                                          
                                                          
                                                          $
                                                          26.30
                                                          
                                                          
                                                          $
                                                          .19
                                                          
                                                          
                                                          $
                                                          25.50
                                                          
                                                          
                                                          $
                                                          28.00
                                                          
                                                          
                                                          $
                                                          .19Second
      Quarter
                                                          
                                                          $
                                                          22.50
                                                          
                                                          
                                                          $
                                                          25.05
                                                          
                                                          
                                                          $
                                                          .19
                                                          
                                                          
                                                          $
                                                          26.05
                                                          
                                                          
                                                          $
                                                          30.50
                                                          
                                                          
                                                          $
                                                          .19Third
      Quarter
                                                          
                                                          $
                                                          22.35
                                                          
                                                          
                                                          $
                                                          25.50
                                                          
                                                          
                                                          $
                                                          .19
                                                          
                                                          
                                                          $
                                                          27.60
                                                          
                                                          
                                                          $
                                                          30.00
                                                          
                                                          
                                                          $
                                                          .19Fourth
      Quarter
                                                          
                                                          $
                                                          18.05
                                                          
                                                          
                                                          $
                                                          24.00
                                                          
                                                          
                                                          $
                                                          .19
                                                          
                                                          
                                                          $
                                                          26.30
                                                          
                                                          
                                                          $
                                                          30.00
                                                          
                                                          
                                                          $
                                                          .19




18


The
following table discloses the number of outstanding options, warrants and rights
granted by the Company to participants in equity compensation plans, as well as
the number of securities remaining available for future issuance under these
plans. The table provides this information separately for equity compensation
plans that have and have not been approved by security holders.





(a)
                                          
                                          
                                          (b)
                                          
                                          
                                          (c)Number
      of securities to
                                            be
      issued upon exercise
                                            of
      outstanding options,
                                            warrants
      and rights
                                          
                                          
                                          Weighted-average
      exercise
                                            price
      of outstanding options,
                                            warrants
      and rights
                                          
                                          
                                          Number
      of securities remaining
                                            available
      for future issuance under
                                            equity
      compensation plans
                                            {excluding
      securities reflected in column (a) }*Equity
      compensation plansapproved
      by stockholders
                                          
                                          
                                          33,549
                                          
                                          
                                          $
                                          21.78
                                          
                                          
                                          
                                          65,751Equity
      compensation plansnot
      approved by stockholders
                                          
                                          
                                          0
                                          
                                          
                                          
                                          0
                                          
                                          
                                          
                                          0Total
                                          
                                          
                                          33,549
                                          
                                          
                                          $
                                          21.78
                                          
                                          
                                          
                                          65,751




*
Securities for future issuance are reserved and issued at the discretion of the
Board of Directors on an annual basis.





The
following table discloses the purchases made by the Company of shares of its
common stock in the fourth quarter of 2008.





MONTH
                                
                                Total
      number of shares purchased
                                
                                
                                Average
      price paid per share
                                
                                
                                Total
      number of shares purchased as part of publicly announced plans or
      programs
                                
                                
                                Maximum
      number of shares that may yet be purchased under the plans or programs
      (1)October
      1, 2008 – October 31, 2008
                                
                                
                                0
                                
                                
                                $
                                0
                                
                                
                                
                                0
                                
                                
                                
                                65,751November
      1, 2008 – November 30, 2008
                                
                                
                                0
                                
                                
                                $
                                0
                                
                                
                                
                                0
                                
                                
                                
                                65,751December
      1, 2008 – December 31, 2008
                                
                                
                                0
                                
                                
                                $
                                0
                                
                                
                                
                                0
                                
                                
                                
                                65,751Total
                                
                                
                                0
                                
                                
                                $
                                0
                                
                                
                                
                                0





(1) On
July 2, 2001, the Board of Directors authorized the repurchase of 158,931 shares
of the Corporation’s common stock outstanding from shareholders.





The
performance graph formerly included in the Company’s Proxy Statement can now be
found in the Company’s Annual Report to its shareholders.




19





ITEM 6 SELECTED FINANCIAL
DATA




Consolidated
Financial Highlights


(Dollars
In Thousands, except Per Share Data)


At
      and For the Years Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006
                    
                    
                    2005
                    
                    
                    2004Net
      Income
                    
                    $
                    3,039
                    
                    
                    $
                    4,871
                    
                    
                    $
                    4,129
                    
                    
                    $
                    4,476
                    
                    
                    $
                    4,453Return
      of Average Assets
                    
                    
                    0.68
                    %
                    
                    
                    1.17
                    %
                    
                    
                    1.03
                    %
                    
                    
                    1.16
                    %
                    
                    
                    1.18
                    %Return
      on Average Equity
                    
                    
                    7.53
                    %
                    
                    
                    11.85
                    %
                    
                    
                    10.55
                    %
                    
                    
                    11.37
                    %
                    
                    
                    10.84
                    %Shareholders'
      ValueEarnings
      per Share, Basic
                    
                    $
                    0.97
                    
                    
                    $
                    1.55
                    
                    
                    $
                    1.31
                    
                    
                    $
                    1.42
                    
                    
                    $
                    1.41Earnings
      per Share, Diluted
                    
                    
                    0.97
                    
                    
                    
                    1.55
                    
                    
                    
                    1.31
                    
                    
                    
                    1.41
                    
                    
                    
                    1.40Regular
      Cash Dividends
                    
                    
                    0.76
                    
                    
                    
                    0.76
                    
                    
                    
                    0.76
                    
                    
                    
                    0.76
                    
                    
                    
                    0.73Special
      Cash Dividends
                    
                    
                    0.00
                    
                    
                    
                    0.00
                    
                    
                    
                    0.00
                    
                    
                    
                    1.00
                    
                    
                    
                    0.00Book
      Value
                    
                    
                    12.69
                    
                    
                    
                    13.64
                    
                    
                    
                    13.16
                    
                    
                    
                    12.55
                    
                    
                    
                    13.42Market
      Value at End of the Year
                    
                    
                    18.05
                    
                    
                    
                    26.30
                    
                    
                    
                    26.00
                    
                    
                    
                    31.45
                    
                    
                    
                    36.00Market
      Value/Book Value Ratio
                    
                    
                    142.24
                    %
                    
                    
                    192.82
                    %
                    
                    
                    197.57
                    %
                    
                    
                    250.60
                    %
                    
                    
                    268.26
                    %Price
      Earnings Multiple
                    
                    
                    18.61
                    X
                    
                    
                    16.97
                    X
                    
                    
                    19.85
                    X
                    
                    
                    22.14
                    X
                    
                    
                    25.59
                    XDividend
      Payout Ratio
                    
                    
                    78.35
                    %
                    
                    
                    48.92
                    %
                    
                    
                    57.93
                    %
                    
                    
                    53.50
                    %
                    
                    
                    51.91
                    %Dividend
      Yield
                    
                    
                    4.21
                    %
                    
                    
                    2.89
                    %
                    
                    
                    2.94
                    %
                    
                    
                    2.42
                    %
                    
                    
                    2.03
                    %Safety and
      SoundnessStockholders'
      Equity/Asset Ratio
                    
                    
                    8.41
                    %
                    
                    
                    9.85
                    %
                    
                    
                    9.91
                    %
                    
                    
                    10.13
                    %
                    
                    
                    11.16
                    %Allowance
      for Loan Loss as a Percent of Loans
                    
                    
                    0.95
                    %
                    
                    
                    0.84
                    %
                    
                    
                    0.66
                    %
                    
                    
                    0.92
                    %
                    
                    
                    1.12
                    %Net
      Charge Offs/Total Loans
                    
                    
                    0.05
                    %
                    
                    
                    (0.13
                    %)
                    
                    
                    0.33
                    %
                    
                    
                    0.29
                    %
                    
                    
                    0.17
                    %Allowance
      for Loan Loss/Nonaccrual Loans
                    
                    
                    498.67
                    %
                    
                    
                    620.51
                    %
                    
                    
                    402.70
                    %
                    
                    
                    206.62
                    %
                    
                    
                    132.77
                    %Allowance
      for Loan Loss/Non-performing Loans
                    
                    
                    58.68
                    %
                    
                    
                    620.51
                    %
                    
                    
                    248.89
                    %
                    
                    
                    183.74
                    %
                    
                    
                    116.29
                    %Balance Sheet
      HighlightsTotal
      Assets
                    
                    $
                    472,376
                    
                    
                    $
                    434,434
                    
                    
                    $
                    416,268
                    
                    
                    $
                    391,198
                    
                    
                    $
                    379,375Total
      Investments
                    
                    
                    110,247
                    
                    
                    
                    112,746
                    
                    
                    
                    110,302
                    
                    
                    
                    108,313
                    
                    
                    
                    113,598Net
      Loans
                    
                    
                    313,606
                    
                    
                    
                    288,601
                    
                    
                    
                    269,383
                    
                    
                    
                    256,870
                    
                    
                    
                    242,075Allowance
      for Loan Losses
                    
                    
                    3,002
                    
                    
                    
                    2,451
                    
                    
                    
                    1,792
                    
                    
                    
                    2,375
                    
                    
                    
                    2,739Short-term
      Borrowings
                    
                    
                    18,432
                    
                    
                    
                    22,848
                    
                    
                    
                    12,574
                    
                    
                    
                    17,842
                    
                    
                    
                    14,614Long-term
      Borrowings
                    
                    
                    39,691
                    
                    
                    
                    38,534
                    
                    
                    
                    36,525
                    
                    
                    
                    34,770
                    
                    
                    
                    46,034Total
      Deposits
                    
                    
                    371,268
                    
                    
                    
                    327,430
                    
                    
                    
                    323,613
                    
                    
                    
                    296,962
                    
                    
                    
                    274,775Stockholders'
      Equity
                    
                    
                    39,720
                    
                    
                    
                    42,805
                    
                    
                    
                    41,240
                    
                    
                    
                    39,616
                    
                    
                    
                    42,354
  20




ITEM
7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS





This
consolidated review and analysis of Peoples Financial Services Corp. (the
Company) is intended to assist the reader in evaluating the Company’s
performance for the years ending December 31 2008, 2007, and 2006. The
information should be read in conjunction with the consolidated financial
statements and the accompanying notes to those statements.





Peoples
Financial Services Corp. (the Company) is the one-bank holding company of
Peoples National Bank (the Bank), which is wholly owned by the Company. The
Company and the Bank derive their primary income from the operation of a
commercial bank, including earning interest on loans and investment securities.
The Bank incurs interest expense in relation to deposits and other borrowings.
The Bank operates eleven full-service branches in the Hallstead Shopping Plaza,
Hop Bottom, Montrose, Susquehanna, Nicholson, Tunkhannock, Meshoppen, and
Glenburn Pennsylvania and Conklin, Village of Deposit and Town of Chenango,
Broome County, New York. The Bank has on-site automated teller machines at all
offices except Hop Bottom and Meshoppen. The administrative offices and
operations offices are located in Hallstead, Pennsylvania. Principal market
areas are Susquehanna, Wyoming Counties and northern Lackawanna County in
Pennsylvania and the Southern Tier of Broome County, New York and the bordering
areas of those counties. As of December 31, 2008, the Bank employed 113
full-time employees and 26 part-time employees.





Forward
Looking Statements


When used
in this discussion, the words “believes”, “anticipates”, “contemplated”,
“expects”, or similar expressions are intended to identify forward looking
statements. Such statements are subject to certain risks and uncertainties that
could cause actual results to differ materially from those projected. Those
risks and uncertainties include changes in interest rates, the ability to
control costs and expenses, and general economic conditions. The Company
undertakes no obligation to publicly release the results of any revisions to
those forward looking statements that may be made to reflect events or
circumstances after this date or to reflect the occurrence of unanticipated
events.





Critical
Accounting Policies


Note 1 to
the Company’s consolidated financial statements lists significant accounting
policies used in the development and presentation of its financial statements.
This discussion and analysis, the significant accounting policies, and other
financial statement disclosures identify and address key variables and other
qualitative and quantitative factors that are necessary for an understanding and
evaluation of the Company and its results of operations.





The
consolidated financial statements are prepared in accordance with accounting
principles generally accepted in the United States, which require the Company to
make estimates and assumptions. The Company believes that its determination of
the allowance for loan losses involves a higher degree of judgment and
complexity than the Company’s other significant accounting policies. Further,
these estimates can be materially impacted by changes in market conditions or
the actual or perceived financial condition of the Company’s borrowers,
subjecting the Company to significant volatility of earnings.





The
allowance for loan losses is established through the provision for loan losses,
which is a charge against earnings. Provisions for loan losses are made to
reserve for estimated probable losses on loans. The allowance for loan losses is
a significant estimate and is regularly evaluated by the Company for adequacy by
taking into consideration factors such as changes in the nature and volume of
the loan portfolio, trends in actual and forecasted credit quality, including
delinquency, charge-off and bankruptcy rates, and current economic conditions
that may affect a borrower’s ability to pay. The use of different estimates of
assumptions could produce a different provision for loan losses. For additional
discussion concerning the Company’s allowance for loan losses and related
matters, see “Provision for Loan Losses”.





The
Company considers current economic conditions and the appraised value of any
underlying collateral when determining the estimated value of foreclosed
properties. In determining the necessity of recording an other-than-temporary
impairment on securities owned by the Company, three main characteristics are
considered; the length of time and extent to which a security has been “under
water”, the financial condition and current outlook of the issuer and finally,
the intent and ability of the Company to hold the security until such a time in
which there is a full recovery in fair value.




In
estimating  other-than-temporary  impairment  losses
on securities,  the Company  considers  1) the
length of time and extent to which the fair value has been less than cost 2)
the  financial  condition of the issuer and 3) the intent
and ability of the Company to hold the  security to allow for a
recovery to fair value. The Company believes that the unrealized losses, at
December 31, 2008 and 2007 represent temporary impairment of the
securities.
 
   Restricted
stock which represents  required  investment in the common
stock of correspondent  banks is carried at cost and as of December
31, 2008 and 2007, consists  of the  common  stock
of  Federal  Home  Loan Bank
of  Pittsburgh.  In
December  2008,  the  FHLB  of  Pittsburgh  notified  member  banks  that
it was suspending dividend payments and the repurchase of capital
stock.
 
 Management
evaluates the restricted stock for impairment in accordance with
Statement  of
Position  (SOP)01-6,  Accounting  by
Certain  Entities  (Including Entities  With
Trade  Receivables)  That Lend to or
Finance  the  Activities  of
Others.  Management's determination of whether these investments are
impaired is based on their  assessment of the
ultimate  recoverability  of their cost rather than by
recognizing  temporary  decline in value. The determination
of whether a decline  affects
the  ultimate  recoverability  of their cost
is  influenced  by criteria such as (1)
the  significance  of the decline in net assets of the FHLB
as  compared to
the  capital  stock  amount for the FHLB and
length of time this situation has persisted,  (2) commitments by the
FHLB to make payments  required by law or regulation and the level of
such payments in relation to the operating performance  of the
FHLB,  and (3)
the  impact  of  legislative  and  regulatory
changes
on  institutions  and,  accordingly,  on
the customer  base of the
FHLB.  Management  believes no impairment charge is
necessary related to the restricted stock as of December 31, 2008.


21


Prior to
January 1, 2006 and as previously permitted by SFAS No. 123, the Company
accounted for stock-based compensation in accordance with Accounting Principles
Board Opinion (APB) No. 25. Under APB No. 25, no compensation expense was
recognized in the income statement related to any option granted under the
Company stock option plans. In December 2004, the Financial Accounting Standards
Board (FASB) issued Statement No. 123(R), “Share-Based Payment.” Statement No.
123(R) replaced Statement No. 123, “Accounting for Stock-Based Compensation,”
and superseded APB Opinion No. 25, “Accounting for Stock Issued to
Employees.”  Statement No. 123(R) requires compensation costs related
to share-based payment transactions to be recognized in the financial statements
over the period that an employee provides service in exchange for the
award.  Public companies were required to adopt the new standard using
a modified prospective method and were given the option of restating prior
periods using the modified retrospective method.  The Bank did not
elect to use the modified retrospective method.  Under the modified
prospective method, companies are required to record compensation cost for new
and modified awards over the related vesting period of such awards prospectively
and record compensation cost prospectively for the unvested portion, at the date
of adoption, of previously issued and outstanding awards over the remaining
vesting period of such awards.  No change to prior periods presented
is permitted under the modified prospective method.  Statement No.
123(R) became effective for annual reporting periods beginning after December
15, 2005.  Adopting Statement No. 123(R) on January 1, 2006 using the
modified prospective method, the Company incurred total stock-based compensation
expense, net of related tax effects, in the amount of $1,000, $3,000, and $3,000
for the years ended December 31, 2008, 2007, and 2006 respectively.





RESULTS OF
OPERATIONS


Net
Interest Income


Net
interest income is the main source of the Company’s income. It is the difference
between interest earned on assets and interest paid on liabilities. The
discussion of net interest income should be read in conjunction with Table 2:
“Distribution of Assets, Liabilities and Stockholders’ Equity; Interest Rates
and Interest Differential”, and Table 3: “Rate/Volume Analysis of Changes in Net
Interest Income.”





The
following table shows the net interest income on a fully-tax-equivalent basis
for each of the three years ended December 2008, 2007, and 2006.





TABLE
1





Net
Interest Income


(In
Thousands)
  Year-Ended
      December 31,2008
                                                            
                                                            
                                                            2007
                                                            
                                                            
                                                            2006Total
      Interest Income
                                                            
                                                            $
                                                            25,479
                                                            
                                                            
                                                            $
                                                            24,611
                                                            
                                                            
                                                            $
                                                            22,698Tax
      Exempt Loans
                                                            
                                                            
                                                            518
                                                            
                                                            
                                                            
                                                            486
                                                            
                                                            
                                                            
                                                            439Non-Taxable
      Securities
                                                            
                                                            
                                                            892
                                                            
                                                            
                                                            
                                                            885
                                                            
                                                            
                                                            
                                                            764Total
      Tax Equivalent Adjustment
                                                            
                                                            
                                                            1,410
                                                            
                                                            
                                                            
                                                            1,371
                                                            
                                                            
                                                            
                                                            1,203Total
      Tax Equivalent Interest Income
                                                            
                                                            
                                                            26,889
                                                            
                                                            
                                                            
                                                            25,982
                                                            
                                                            
                                                            
                                                            23,901Total
      Interest Expense
                                                            
                                                            
                                                            9,154
                                                            
                                                            
                                                            
                                                            11,105
                                                            
                                                            
                                                            
                                                            10,797Net
      Interest Income (Fully Tax Equivalent Basis)
                                                            
                                                            $
                                                            17,735
                                                            
                                                            
                                                            $
                                                            14,877
                                                            
                                                            
                                                            $
                                                            13,104
  Table 2
includes the average balances, interest income and expense, and the average
rates earned and paid for assets and liabilities.  For yield
calculation purposes, non-accruing loans are included in average loan balances.
Table 3 analyzes the components contributing to the changes in net interest
income and indicates the impact in either changes in rate or changes in
volume.


22




TABLE
2


Distribution
of Assets, Liabilities and Stockholders' Equity


Interest
Rates and Interest Differential


(Dollars
In Thousands)


Year
      Ended
                                                December
      31, 2008
                                              
                                              
                                              Year
      Ended
                                                December
      31, 2007
                                              
                                              
                                              Year
      Ended
                                                December
      31, 2006Average
                                              
                                              
                                              
                                              Yield/
                                              
                                              
                                              Average
                                              
                                              
                                              
                                              Yield/
                                              
                                              
                                              Average
                                              
                                              
                                              
                                              Yield/ASSETS
                                              
                                              Balance
                                              
                                              Interest
                                              
                                              Rate
                                              
                                              
                                              Balance
                                              
                                              Interest
                                              
                                              Rate
                                              
                                              
                                              Balance
                                              
                                              Interest
                                              
                                              RateLoansReal
      Estate
                                              
                                              $
                                              117,635
                                              
                                              $
                                              7,602
                                              
                                              6.46
                                              %
                                              
                                              $
                                              115,490
                                              
                                              $
                                              7,615
                                              
                                              6.59
                                              %
                                              
                                              $
                                              110,972
                                              
                                              $
                                              7,136
                                              
                                              6.43
                                              %Installment
                                              
                                              
                                              16,815
                                              
                                              
                                              1,303
                                              
                                              7.75
                                              %
                                              
                                              
                                              17,143
                                              
                                              
                                              1,442
                                              
                                              8.41
                                              %
                                              
                                              
                                              17,210
                                              
                                              
                                              1,417
                                              
                                              8.23
                                              %Commercial
                                              
                                              
                                              140,903
                                              
                                              
                                              9,917
                                              
                                              7.04
                                              %
                                              
                                              
                                              123,854
                                              
                                              
                                              9,424
                                              
                                              7.61
                                              %
                                              
                                              
                                              118,904
                                              
                                              
                                              8,532
                                              
                                              7.18
                                              %Tax
      Exempt
                                              
                                              
                                              22,913
                                              
                                              
                                              1,005
                                              
                                              6.65
                                              %
                                              
                                              
                                              21,165
                                              
                                              
                                              943
                                              
                                              6.75
                                              %
                                              
                                              
                                              20,051
                                              
                                              
                                              853
                                              
                                              6.45
                                              %Other
      Loans
                                              
                                              
                                              469
                                              
                                              
                                              44
                                              
                                              9.38
                                              %
                                              
                                              
                                              467
                                              
                                              
                                              57
                                              
                                              12.21
                                              %
                                              
                                              
                                              473
                                              
                                              
                                              58
                                              
                                              12.26
                                              %Total
      Loans
                                              
                                              
                                              298,735
                                              
                                              
                                              19,871
                                              
                                              6.83
                                              %
                                              
                                              
                                              278,119
                                              
                                              
                                              19,481
                                              
                                              7.18
                                              %
                                              
                                              
                                              267,610
                                              
                                              
                                              17,996
                                              
                                              6.89
                                              %Investment
      Securities  (AFS)Taxable
                                              
                                              
                                              67,897
                                              
                                              
                                              3,771
                                              
                                              5.55
                                              %
                                              
                                              
                                              65,438
                                              
                                              
                                              3,351
                                              
                                              5.12
                                              %
                                              
                                              
                                              65,202
                                              
                                              
                                              3,032
                                              
                                              4.65
                                              %Non-Taxable
                                              
                                              
                                              42,859
                                              
                                              
                                              1,731
                                              
                                              6.12
                                              %
                                              
                                              
                                              44,192
                                              
                                              
                                              1,717
                                              
                                              5.89
                                              %
                                              
                                              
                                              39,435
                                              
                                              
                                              1,484
                                              
                                              5.70
                                              %Total
      Securities
                                              
                                              
                                              110,756
                                              
                                              
                                              5,502
                                              
                                              5.77
                                              %
                                              
                                              
                                              109,630
                                              
                                              
                                              5,068
                                              
                                              5.43
                                              %
                                              
                                              
                                              104,637
                                              
                                              
                                              4,516
                                              
                                              5.05
                                              %Time
      Deposits With Other Banks
                                              
                                              
                                              1,186
                                              
                                              
                                              26
                                              
                                              2.19
                                              %
                                              
                                              
                                              315
                                              
                                              
                                              18
                                              
                                              5.71
                                              %
                                              
                                              
                                              932
                                              
                                              
                                              53
                                              
                                              5.69
                                              %Fed
      Funds Sold
                                              
                                              
                                              6,817
                                              
                                              
                                              80
                                              
                                              1.17
                                              %
                                              
                                              
                                              723
                                              
                                              
                                              44
                                              
                                              6.09
                                              %
                                              
                                              
                                              2,467
                                              
                                              
                                              133
                                              
                                              5.39
                                              %Total
      Earning Assets
                                              
                                              
                                              417,494
                                              
                                              
                                              25,479
                                              
                                              6.44
                                              %
                                              
                                              
                                              388,787
                                              
                                              
                                              24,611
                                              
                                              6.68
                                              %
                                              
                                              
                                              375,646
                                              
                                              
                                              22,698
                                              
                                              6.36
                                              %Less:
      Allowance for Loan Losses
                                              
                                              
                                              (2,599
                                              )
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              (2,025
                                              )
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              (2,344Cash
      and Due from Banks
                                              
                                              
                                              6,851
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              6,639
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              6,768Premises
      and Equipment, Net
                                              
                                              
                                              6,227
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              5,712
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              7,816Other
      Assets
                                              
                                              
                                              19,741
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              17,690
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              12,899Total
      Assets
                                              
                                              $
                                              447,714
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              416,803
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              400,785LIABILITIES
      AND
                                                STOCKHOLDERS’
      EQUITYDepositsInterest
      Bearing Demand
                                              
                                              $
                                              28,871
                                              
                                              
                                              284
                                              
                                              0.98
                                              %
                                              
                                              $
                                              25,341
                                              
                                              
                                              290
                                              
                                              1.14
                                              %
                                              
                                              $
                                              25,462
                                              
                                              
                                              262
                                              
                                              1.03
                                              %Regular
      Savings
                                              
                                              
                                              94,019
                                              
                                              
                                              1,219
                                              
                                              1.30
                                              %
                                              
                                              
                                              106,969
                                              
                                              
                                              3,311
                                              
                                              3.10
                                              %
                                              
                                              
                                              95,360
                                              
                                              
                                              3,135
                                              
                                              3.29
                                              %Money
      Market  Savings
                                              
                                              
                                              33,858
                                              
                                              
                                              600
                                              
                                              1.77
                                              %
                                              
                                              
                                              35,355
                                              
                                              
                                              1,089
                                              
                                              3.08
                                              %
                                              
                                              
                                              37,747
                                              
                                              
                                              1,446
                                              
                                              3.83
                                              %Time
                                              
                                              
                                              132,313
                                              
                                              
                                              4,923
                                              
                                              3.72
                                              %
                                              
                                              
                                              102,643
                                              
                                              
                                              4,329
                                              
                                              4.22
                                              %
                                              
                                              
                                              102,195
                                              
                                              
                                              3,905
                                              
                                              3.82
                                              %Total
      Interest Bearing Deposits
                                              
                                              
                                              289,061
                                              
                                              
                                              7,026
                                              
                                              2.43
                                              %
                                              
                                              
                                              270,308
                                              
                                              
                                              9,019
                                              
                                              3.34
                                              %
                                              
                                              
                                              260,764
                                              
                                              
                                              8,748
                                              
                                              3.35
                                              %Other
      Borrowings
                                              
                                              
                                              58,368
                                              
                                              
                                              2,128
                                              
                                              3.65
                                              %
                                              
                                              
                                              50,183
                                              
                                              
                                              2,086
                                              
                                              4.16
                                              %
                                              
                                              
                                              48,878
                                              
                                              
                                              2,049
                                              
                                              4.19
                                              %Total
      Interest Bearing Liabilities
                                              
                                              
                                              347,429
                                              
                                              
                                              9,154
                                              
                                              2.63
                                              %
                                              
                                              
                                              320,491
                                              
                                              
                                              11,105
                                              
                                              3.46
                                              %
                                              
                                              
                                              309,642
                                              
                                              
                                              10,797
                                              
                                              3.49
                                              %Net
      Interest Spread
                                              
                                              
                                              
                                              
                                              $
                                              16,325
                                              
                                              3.81
                                              %
                                              
                                              
                                              
                                              
                                              $
                                              13,506
                                              
                                              3.22
                                              %
                                              
                                              
                                              
                                              
                                              $
                                              11,901
                                              
                                              2.88
                                              %Non-Interest
      BearingDemand
      Deposits
                                              
                                              
                                              56,778
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              52,613
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              49,888Accrued
      Expenses andOther
      Liabilities
                                              
                                              
                                              3,173
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              2,604
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              2,135Stockholders'
      Equity
                                              
                                              
                                              40,334
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              41,095
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              39,120Total
      Liabilities andStockholders'
      Equity
                                              
                                              $
                                              447,714
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              416,803
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              400,785Interest
      Income/Earning Assets
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              6.44
                                              %
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              6.68
                                              %
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              6.36
                                              %Interest
      Expense/Earning Assets
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              2.19
                                              %
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              2.86
                                              %
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              2.87
                                              %Net
      Interest Margin
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              4.25
                                              %
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              3.82
                                              %
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              3.49
                                              %


23


TABLE
3





Rate/Volume Analysis of Changes in
Net Interest Income


(In
Thousands)
 2008
      to 2007
                                            
                                            
                                            2007
      to 2006Increase
      (Decrease)
                                            
                                            
                                            Change Due to Rate
                                            
                                            
                                            Volume
                                            
                                            
                                            Increase
      (Decrease)
                                            
                                            
                                            Change Due to Rate
                                            
                                            
                                            VolumeInterest
      IncomeReal
      Estate Loans
                                            
                                            $
                                            (13
                                            )
                                            
                                            $
                                            (152
                                            )
                                            
                                            $
                                            139
                                            
                                            
                                            $
                                            479
                                            
                                            
                                            $
                                            181
                                            
                                            
                                            $
                                            298Installment
      Loans
                                            
                                            
                                            (139
                                            )
                                            
                                            
                                            (114
                                            )
                                            
                                            
                                            (25
                                            )
                                            
                                            
                                            25
                                            
                                            
                                            
                                            31
                                            
                                            
                                            
                                            (6
                                            )Commercial
      Loans
                                            
                                            
                                            493
                                            
                                            
                                            
                                            (707
                                            )
                                            
                                            
                                            1,200
                                            
                                            
                                            
                                            892
                                            
                                            
                                            
                                            515
                                            
                                            
                                            
                                            377Tax
      Exempt Loans
                                            
                                            
                                            62
                                            
                                            
                                            
                                            (15
                                            )
                                            
                                            
                                            77
                                            
                                            
                                            
                                            90
                                            
                                            
                                            
                                            15
                                            
                                            
                                            
                                            75Other
      Loans
                                            
                                            
                                            (13
                                            )
                                            
                                            
                                            (13
                                            )
                                            
                                            
                                            0
                                            
                                            
                                            
                                            (1
                                            )
                                            
                                            
                                            0
                                            
                                            
                                            
                                            (1
                                            )Total
      Loans
                                            
                                            
                                            390
                                            
                                            
                                            
                                            (1,001
                                            )
                                            
                                            
                                            1,391
                                            
                                            
                                            
                                            1,485
                                            
                                            
                                            
                                            742
                                            
                                            
                                            
                                            743Investment
      Securities (AFS)Taxable
                                            
                                            
                                            420
                                            
                                            
                                            
                                            283
                                            
                                            
                                            
                                            137
                                            
                                            
                                            
                                            319
                                            
                                            
                                            
                                            307
                                            
                                            
                                            
                                            12Non-Taxable
                                            
                                            
                                            14
                                            
                                            
                                            
                                            68
                                            
                                            
                                            
                                            (54
                                            )
                                            
                                            
                                            233
                                            
                                            
                                            
                                            (47
                                            )
                                            
                                            
                                            280Total
      Securities (AFS)
                                            
                                            
                                            434
                                            
                                            
                                            
                                            351
                                            
                                            
                                            
                                            83
                                            
                                            
                                            
                                            552
                                            
                                            
                                            
                                            260
                                            
                                            
                                            
                                            292Time
      Deposits with Other Banks
                                            
                                            
                                            8
                                            
                                            
                                            
                                            (11
                                            )
                                            
                                            
                                            19
                                            
                                            
                                            
                                            (35
                                            )
                                            
                                            
                                            0
                                            
                                            
                                            
                                            (35
                                            )Fed
      Funds Sold
                                            
                                            
                                            36
                                            
                                            
                                            
                                            (36
                                            )
                                            
                                            
                                            72
                                            
                                            
                                            
                                            (89
                                            )
                                            
                                            
                                            20
                                            
                                            
                                            
                                            (109
                                            )Total
      Interest Income
                                            
                                            
                                            868
                                            
                                            
                                            
                                            (697
                                            )
                                            
                                            
                                            1,565
                                            
                                            
                                            
                                            1,913
                                            
                                            
                                            
                                            1,022
                                            
                                            
                                            
                                            891Interest
      ExpenseInterest
      Bearing Demand Deposits
                                            
                                            
                                            (6
                                            )
                                            
                                            
                                            (41
                                            )
                                            
                                            
                                            35
                                            
                                            
                                            
                                            28
                                            
                                            
                                            
                                            29
                                            
                                            
                                            
                                            (1
                                            )Regular
      Savings Deposits
                                            
                                            
                                            (2,092
                                            )
                                            
                                            
                                            (1,924
                                            )
                                            
                                            
                                            (168
                                            )
                                            
                                            
                                            176
                                            
                                            
                                            
                                            (183
                                            )
                                            
                                            
                                            359Money
      Market Savings Deposits
                                            
                                            
                                            (489
                                            )
                                            
                                            
                                            (462
                                            )
                                            
                                            
                                            (27
                                            )
                                            
                                            
                                            (357
                                            )
                                            
                                            
                                            (283
                                            )
                                            
                                            
                                            (74
                                            )Time
      Deposits
                                            
                                            
                                            594
                                            
                                            
                                            
                                            (510
                                            )
                                            
                                            
                                            1,104
                                            
                                            
                                            
                                            424
                                            
                                            
                                            
                                            405
                                            
                                            
                                            
                                            19Total
      Interest Bearing Deposits
                                            
                                            
                                            (1,993
                                            )
                                            
                                            
                                            (2,937
                                            )
                                            
                                            
                                            944
                                            
                                            
                                            
                                            271
                                            
                                            
                                            
                                            (32
                                            )
                                            
                                            
                                            303Other
      Borrowings
                                            
                                            
                                            42
                                            
                                            
                                            
                                            (256
                                            )
                                            
                                            
                                            298
                                            
                                            
                                            
                                            37
                                            
                                            
                                            
                                            (17
                                            )
                                            
                                            
                                            54Total
      Interest Expense
                                            
                                            
                                            (1,951
                                            )
                                            
                                            
                                            (3,193
                                            )
                                            
                                            
                                            1,242
                                            
                                            
                                            
                                            308
                                            
                                            
                                            
                                            (49
                                            )
                                            
                                            
                                            357Net
      Interest Spread
                                            
                                            $
                                            2,819
                                            
                                            
                                            $
                                            2,496
                                            
                                            
                                            $
                                            323
                                            
                                            
                                            $
                                            1,605
                                            
                                            
                                            $
                                            1,071
                                            
                                            
                                            $
                                            534




Interest
income on total loans increased in 2008. This increase of $390,000 is shown in
Table 3. The table shows that there was an increase of $1,391,000 due to volume
and the drop in interest rates attributed a decrease in income of $1,001,000 in
2008. This compares to an increase of $743,000 due to volume and $742,000 due to
increases in rate in 2007.  Lower interest rates in 2008 had a severe
impact on the Bank’s interest income mitigated by loan growth.  To
view the loan portfolio growth numbers and interest yields see Table 2 which
shows the average balance in loans increased from $278,119,000 in 2007 to
$298,735,000 in 2008 and the yield in loans dropped from 7.18% in 2007 to 6.83%
in 2008.





In 2008,
interest income on securities increased $434,000 year over year from
2007.  Table 3 shows that higher rates added $351,000 to that interest
income, and the increase in the average balance added another $83,000 to
income.  The average investments as shown in Table 2 were $110,756,000
in 2008 compared to $109,630,000 in 2007. In comparison, in 2007 interest income
on securities increased $552,000 year over year with a $260,000 gain due to
higher rates and an increase of $292,000 due to volume.





Interest
income from federal funds sold increased $36,000 from 2007 to 2008 because of
higher balances maintained in 2008. The change in interest income from fed funds
sold in the previous year, from 2007 to 2006, was largely due to decreases in
balances rather than rate.  Average federal funds sold balance was
$6,817,000 in 2008 compared to $723,000 in 2007.  Average federal
funds sold were $2,467,000 in 2006. Interest income from time deposits with
other banks also increased $8,000 in 2008 primarily due to higher
balances.


24


On the
interest expense side, overall interest expenses decreased by
$1,951,000.  Of this total, $3,193,000 was directly attributable to
reductions in interest rates.  In 2008, the bank had significant
deposit growth at a cost of $944,000 in additional interest expense for those
deposits. In 2007, interest expense increased $308,000 from the previous
year.  Of this increase $303,000 was due to growth in deposit accounts
and $32,000 was due to reduction in interest rates.  The average
balance in interest earning deposits was $270,308,000 in 2007 as compared to
$289,061,000 in 2008. Other borrowed funds costs also increased in 2008. The
total increase was $42,000 of which $298,000 was due to volume and $256,000 was
saved on rate. In 2007, Other Borrowings expense increased $37,000. Of this
increase $54,000 was due to the growth in borrowed funds and $17,000 was saved
due to lower rates.  The average balance of borrowed funds was
$50,183,000 in 2007 compared to $58,368,000 in 2008.





The last
line in Table 3 shows that the net interest spread increased $2,819,000 in 2008
compared to an increase of $1,605,000 in 2007. Table 3 shows the positive impact
that rate changes had on net interest income in both years contributing
$1,071,000 in 2007 and $2,496,000 in 2008. Net growth also remained positive in
both years contributing an additional $534,000 in 2007 and $323,000 in 2008 to
income.





PROVISION FOR LOAN
LOSSES


The
provision and allowance for loan losses are based on management’s ongoing
assessment of the Company’s credit exposure and consideration of other relevant
factors. The allowance for loan losses is a valuation reserve that is available
to absorb future loan charge-offs. The provision for loan losses is the amount
charged to earnings on an annual basis. The factors considered in management’s
assessment of the reasonableness of the allowance for loan losses include
prevailing and anticipated economic conditions, assigned risk ratings on loan
exposures, the results of examinations and appraisals of the loan portfolio
conducted by federal regulatory authorities and an independent loan review firm,
the diversification and size of the loan portfolio, the level of and inherent
risk in non-performing assets, and any other factors deemed relevant by
management.





The
provision for loan losses was $713,000, $280,000 and $302,000 for the years
2008, 2007, and 2006, respectively. Net charge-offs  for 2008 were $162,000
compared to net recoveries of ($379,000) in 2007. As of December 31, 2008, the
allowance for loan loss was .95% of loans and at December 31, 2007, the ratio
was .84% of loans. After allocation of reserves to all non-accrual and
special-mention loans, as well as applying a percentage to outstanding loans
based on the loss history of such loans in each category, the opinion of
management was that the allowance for loan losses was proper and
sufficient.  The allowance for loan losses is maintained at a level
considered adequate to provide for losses that can be reasonably
anticipated.  Management’s periodic evaluation of the adequacy of the
allowance is based on the Bank’s past loan loss experience, known or inherent
risks in the portfolio, adverse situations that may affect the borrower’s
ability to repay, the estimated value of any underlying collateral, composition
of the loan portfolio, current economic conditions and other relevant
factors.  Management believed that certain risks, primarily current
economic conditions, warranted an increase in the allowance for loan losses for
the year ended December 31, 2008. The ratio of allowance for loan loss to
non-performing loans was 58.68% at year end 2008 compared to 620.51% at year end
2007 and 248.89% at year end 2006.


25


The
following table analyzes the increase in total other income by comparing the
years 2008, 2007 and 2006.





TABLE
4





Non-Interest
Income


(Dollars
In Thousands)


Year
      EndedDecember
      31,
                                                    
                                                    
                                                    Variance
      2008
                                                    
                                                    
                                                    Variance
      20072008
                                                    
                                                    
                                                    2007
                                                    
                                                    
                                                    2006
                                                    
                                                    
                                                    Amount
                                                      Of
      Change
                                                    
                                                    
                                                    Percent
                                                      Of
      Change
                                                    
                                                    
                                                    Amount
                                                      Of
      Change
                                                    
                                                    
                                                    Percent
                                                      Of
      ChangeCustomer
      Service Fees
                                                    $
                                                    2,006
                                                    
                                                    
                                                    $
                                                    1,947
                                                    
                                                    
                                                    $
                                                    1,770
                                                    
                                                    
                                                    $
                                                    59
                                                    
                                                    
                                                    
                                                    3.03
                                                    %
                                                    
                                                    $
                                                    177
                                                    
                                                    
                                                    
                                                    10.00
                                                    %Investment
      Division Commission Income
                                                    
                                                    411
                                                    
                                                    
                                                    
                                                    340
                                                    
                                                    
                                                    
                                                    260
                                                    
                                                    
                                                    
                                                    71
                                                    
                                                    
                                                    
                                                    20.88
                                                    %
                                                    
                                                    
                                                    80
                                                    
                                                    
                                                    
                                                    30.77
                                                    %Earnings
      on Investment on Life Insurance
                                                    
                                                    296
                                                    
                                                    
                                                    
                                                    297
                                                    
                                                    
                                                    
                                                    281
                                                    
                                                    
                                                    
                                                    (1
                                                    )
                                                    
                                                    
                                                    (0.34
                                                    %)
                                                    
                                                    
                                                    16
                                                    
                                                    
                                                    
                                                    5.69
                                                    %Other
      Income
                                                    
                                                    606
                                                    
                                                    
                                                    
                                                    626
                                                    
                                                    
                                                    
                                                    437
                                                    
                                                    
                                                    
                                                    (20
                                                    )
                                                    
                                                    
                                                    (3.19
                                                    %)
                                                    
                                                    
                                                    189
                                                    
                                                    
                                                    
                                                    43.25
                                                    %Gains
      on Sale of Interest in Insurance Agency
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    220
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    (220
                                                    )
                                                    
                                                    
                                                    (100.00
                                                    %)
                                                    
                                                    
                                                    220
                                                    
                                                    
                                                    
                                                    100.00
                                                    %Gains
      (Losses) on Security Sales
                                                    
                                                    128
                                                    
                                                    
                                                    
                                                    (122
                                                    )
                                                    
                                                    
                                                    42
                                                    
                                                    
                                                    
                                                    250
                                                    
                                                    
                                                    
                                                    (204.92
                                                    %)
                                                    
                                                    
                                                    (164
                                                    )
                                                    
                                                    
                                                    (390.48
                                                    %)Other
      than Temporary Impairment
                                                    
                                                    (5,256
                                                    )
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    (5,256
                                                    )
                                                    
                                                    
                                                    (100.00
                                                    %)
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    %TOTAL
      Other Income (Loss)
                                                    $
                                                    (1,809
                                                    )
                                                    
                                                    $
                                                    3,308
                                                    
                                                    
                                                    $
                                                    2,790
                                                    
                                                    
                                                    $
                                                    (5,117
                                                    )
                                                    
                                                    
                                                    (154.69
                                                    %)
                                                    
                                                    $
                                                    518
                                                    
                                                    
                                                    
                                                    18.57
                                                    %
  OTHER INCOME


Non-Interest
Income


There was
an overall decrease in non-interest income(loss) to $(1,809,000) in
2008.  This represents a decrease of 154.69% in 2008 when compared to
$3,308,000 in 2007. For comparison, there was an overall increase in
non-interest income of $518,000, or 18.57% in 2007 when compared to $2,790,000
in 2006.





The
non-interest income items that result in these variations are discussed as
follows:





Non-interest
income includes items that are not related to interest rates on loans and
investments, but rather to services rendered and activities conducted in
conjunction with the operation of a commercial bank. Service charges earned on
deposit accounts is the largest single item in this category and represents fees
related to deposit accounts including overdraft fees, minimum balance fees, and
transaction fees. In 2008, service charges and fees increased $59,000, or 3.03%
compared to an increase of $177,000 in 2007, when compared to 2006, or
10.00%.





Commissions
earned by the Investment Division were $411,000 in 2008, compared to $340,000 in
2007, an increase of $71,000, or 20.88%. A strategy was implemented in 2006 in
which the investment division eliminated up front, one time transaction fees in
favor of asset management fees which are earned over the life of an account. The
continued payoff has been a steady income stream from an increasing customer
base. It is the goal of the Company to continue to grow and cultivate this
area.





By
comparison, commissions earned by the Investment Division were $340,000 in 2007,
compared to $260,000 in 2006, an increase of $80,000, or 30.77%. As the
Investment Division grew and became more established, so did the commissions
earned on the assets managed. Additionally, the fee structure implemented in
2006 was responsible for this increase as the Company began to see positive
results from the strategy.





Earnings
on investment in life insurance were $296,000 in 2008, compared to $297,000 in
2007, a decrease of $1,000, or 0.34% as there were no additional investments in
BOLI and the crediting rates applied to the insurance balances remained
steady.





Earnings
on investment in life insurance amounted to $297,000 in 2007, compared to
$281,000 in 2006, an increase of $16,000, or 5.69%.  This was due to
the overall increase in the crediting rate applied to the balances held in
BOLI.  During the latter half of 2007 there was an increase to the
crediting rate on one policy of 151 basis points, another policy increased by 25
basis points and the third BOLI product decreased by 40 basis points. Each BOLI
instrument owned by the Company had a value of between $2 million and $2.6
million at that time and the net increase to the crediting rate was evident in
the income derived from those products.


26


Other
income was $606,000 in 2008, compared to $626,000 in 2007, a decrease of
$20,000, or 3.19%.  This was due to the loss of income recognized
through the operation of the insurance agency which was $70,000 in 2007. Various
sundry accounts contribute to the balance in other income for 2008 when compared
to 2007. Allowing for the loss of income from insurance operations, all other
income accounts would reflect an increase of $50,000, or 8.99%.





Other
income was $626,000 in 2007, compared to $437,000 in 2006, an increase of
$189,000, or 4.32%.  This was primarily due to income recognized
through the operation of the insurance agency which was $70,000 in 2007,
compared to $16,000 in 2006.  This increase accounted for the most
significant portion of the overall increase in other income in
2007.





Gain on
sale of interest in insurance agency was $0 for 2008 compared to $220,000 for
2007.  The Company realized a gain through the sale of its 20%
interest in Community Bankers Insurance Agency (CBIA) in May of 2007. There was
no comparable gain in 2008. The Company does not expect the sale of the
insurance agency to have a significant impact on future earnings.





In 2008,
The Company had $128,000 in realized gains through sales of available-for-sale
securities compared to a loss of $122,000 in 2007.  This is an
increase of $250,000, or 204.92%.  Comparing 2007 to 2006, the Company
had $122,000 in realized losses through sales of available-for-sale securities
compared to a gain of $42,000 in 2006.  This was a decrease of
$164,000 or 390.48%. The decrease experienced in 2007 was due to fewer available
gains through the sale of investment securities. Unlike prior years, when
investment sales were initiated in 2007, market yields were often higher than
the yield on the security sold, the result being an incurred loss on the
security sales.





As
previously mentioned in the discussion of securities, management evaluates
securities for other than temporary impairment at least on a quarterly basis,
and more frequently when economic or market concerns warrant such
evaluation.  Consideration is given to (1) the length of time and the
extent to which the fair value has been less than cost, (2) the financial
condition and near-term prospects of the issuer, and (3) the intent and ability
of the Company to retain its investment in the issuer for a period of time
sufficient to allow for any anticipated recovery in fair value. As such, a
determination was made in 2008 to record other than temporary impairment charges
in relation to five equity positions held by the Company in the amount of
$387,000, 2 preferred equity positions held in the FHLMC (“Freddie Mac’s) in the
amount of $2,289,000 and 2 corporate bonds in the amount of $2,580,000. The
amount of impairment charged against income for the year ended December 31, 2008
was $5,256,000. The charges are not comparable to the same period in
2007.  These, as well as all securities will be monitored in future
quarters for any further deterioration.





As a
result of the Emergency Economic Stabilization Act of 2008 (EESA) the resulting
deferred tax asset created by the other-than-temporary impairment of the
Company’s preferred equity holdings in the FHLMC does not require a valuation
allowance to be recognized. The loss is determined to be ordinary for tax
purposes under the EESA and any future gains realized from selling those FHLMC
holdings would also be treated as ordinary for income tax purposes.  See
Note 9 for further discussion of the realization of deferred tax assets, 
including that portion related to capital losses on equity
securities.





27





TABLE
5





Non-Interest
Expense


(Dollars
In Thousands)


(Dollars
      In Thousands)
                                  
                                  Year
      Ended
                                    December
      31,
                                  
                                  
                                  Variance
      2008
                                  
                                  
                                  Variance
      20072008
                                  
                                  
                                  2007
                                  
                                  
                                  2006
                                  
                                  
                                  Amount
      Of Change
                                  
                                  
                                  Percent
      Of Change
                                  
                                  
                                  Amount
      Of Change
                                  
                                  
                                  Percent
      Of ChangeSalaries
      and Benefits
                                  
                                  $
                                  4,831
                                  
                                  
                                  $
                                  4,767
                                  
                                  
                                  $
                                  4,498
                                  
                                  
                                  $
                                  64
                                  
                                  
                                  
                                  1.34
                                  %
                                  
                                  $
                                  269
                                  
                                  
                                  
                                  5.98
                                  %Occupancy
      Expenses
                                  
                                  
                                  733
                                  
                                  
                                  
                                  788
                                  
                                  
                                  
                                  674
                                  
                                  
                                  
                                  (55
                                  )
                                  
                                  
                                  (6.98
                                  %)
                                  
                                  
                                  114
                                  
                                  
                                  
                                  16.91
                                  %Furniture
      and Equipment Expense
                                  
                                  
                                  493
                                  
                                  
                                  
                                  508
                                  
                                  
                                  
                                  484
                                  
                                  
                                  
                                  (15
                                  )
                                  
                                  
                                  (2.95
                                  %)
                                  
                                  
                                  24
                                  
                                  
                                  
                                  4.96
                                  %FDIC
      Insurance and Assessments
                                  
                                  
                                  227
                                  
                                  
                                  
                                  151
                                  
                                  
                                  
                                  127
                                  
                                  
                                  
                                  76
                                  
                                  
                                  
                                  50.33
                                  %
                                  
                                  
                                  24
                                  
                                  
                                  
                                  18.90
                                  %Professional
      Fees and Outside Services
                                  
                                  
                                  520
                                  
                                  
                                  
                                  371
                                  
                                  
                                  
                                  337
                                  
                                  
                                  
                                  149
                                  
                                  
                                  
                                  40.16
                                  %
                                  
                                  
                                  34
                                  
                                  
                                  
                                  10.09
                                  %Computer
      Services and Supplies
                                  
                                  
                                  970
                                  
                                  
                                  
                                  785
                                  
                                  
                                  
                                  774
                                  
                                  
                                  
                                  185
                                  
                                  
                                  
                                  23.57
                                  %
                                  
                                  
                                  11
                                  
                                  
                                  
                                  1.42
                                  %Taxes,
      Other Than Payroll and Income
                                  
                                  
                                  400
                                  
                                  
                                  
                                  386
                                  
                                  
                                  
                                  370
                                  
                                  
                                  
                                  14
                                  
                                  
                                  
                                  3.63
                                  %
                                  
                                  
                                  16
                                  
                                  
                                  
                                  4.32
                                  %Impairment
      Charge-Other Real Estate
                                  
                                  
                                  0
                                  
                                  
                                  
                                  575
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  (575
                                  )
                                  
                                  
                                  (100.00
                                  %)
                                  
                                  
                                  575
                                  
                                  
                                  
                                  100.00
                                  %Amortization
      Expense-Deposit Premiums
                                  
                                  
                                  258
                                  
                                  
                                  
                                  255
                                  
                                  
                                  
                                  299
                                  
                                  
                                  
                                  3
                                  
                                  
                                  
                                  1.18
                                  %
                                  
                                  
                                  (44
                                  )
                                  
                                  
                                  (14.72
                                  %)Stationary
      and Printing Supplies
                                  
                                  
                                  360
                                  
                                  
                                  
                                  339
                                  
                                  
                                  
                                  247
                                  
                                  
                                  
                                  21
                                  
                                  
                                  
                                  6.19
                                  %
                                  
                                  
                                  92
                                  
                                  
                                  
                                  37.25
                                  %Other
      Operating Expenses
                                  
                                  
                                  1,885
                                  
                                  
                                  
                                  1,641
                                  
                                  
                                  
                                  1,678
                                  
                                  
                                  
                                  244
                                  
                                  
                                  
                                  14.87
                                  %
                                  
                                  
                                  (37
                                  )
                                  
                                  
                                  (2.21
                                  %)Total
      Non-Interest Expense
                                  
                                  $
                                  10,677
                                  
                                  
                                  $
                                  10,566
                                  
                                  
                                  $
                                  9,488
                                  
                                  
                                  $
                                  111
                                  
                                  
                                  
                                  1.05
                                  %
                                  
                                  $
                                  1,078
                                  
                                  
                                  
                                  11.36
                                  %
  OTHER EXPENSES


Non-Interest
Expense


Non-interest
expense includes all other expenses associated with the Company. Total
non-interest expense increased from $10,566,000 in 2007 to $10,677,000 in 2008.
This is an increase of 1.05%. Increases were felt across the board in the
non-interest expense categories with the exception of impairment charges to
other real estate owned, occupancy type expenses and furniture and equipment
costs. Details of the components of non-interest expense are listed
below:





Salaries
and related benefits is the largest expense in this category and it increased
$64,000, or 1.34%, over the year-end 2007. The full-time equivalent number of
employees was 120 as of December 31, 2008, compared to 111 as of December 31,
2007.  The jump in full-time equivalent employees is the result of the
new office opened in Glenburn Township late in 2008. Aside from the increase to
full-time equivalents, normal yearly pay increases and increased health
insurance costs contributed to the overall increase in salary and benefit
expense.





For
comparison, salaries and related benefits increased $269,000, or 5.98%, in 2007
over year-end 2006. The full-time equivalent number of employees was 111 as of
December 31, 2007, compared to 109 as of December 31, 2006. As with the 2008
results, normal yearly pay increases and increased health insurance costs
contributed to the overall increase in salary and benefit expense for
2007.





Occupancy
expense decreased 6.98%, or $55,000, in 2008 when compared to fiscal year 2007.
Unlike 2007, the majority of expenses that comprise occupancy decreased in 2008.
The largest decrease was to repairs and maintenance of buildings. As discussed
in the following paragraph, 2007 included various building maintenance projects
aimed at improving the condition of Company facilities. Those projects were not
duplicated in 2008, thus a savings of approximately $55,000.





This
compares to 2007 when occupancy expense increased 16.91%, or $114,000, when
compared to 2006. Every category of expense related to building occupancy
increased in 2007 when compared to 2006. These categories include utilities,
property taxes, repairs and depreciation.  The category which
increased most substantially however was repairs and maintenance to buildings.
The Company hired a new facilities manager in 2007 and one of the areas of focus
was various projects aimed at improving the overall condition of Company
facilities. This category alone increased by $90,000 which accounted for the
majority of year over year increases between 2007 and 2006.


28


Furniture
and equipment expense also decreased in 2008 to $493,000, or 2.95%, compared to
2007 at $508,000.  The decrease in 2008 is in large part due to the
age of teller equipment which was put in service in 2003. That equipment came at
a substantial cost was fully depreciated midway through 2008 and as a result,
related depreciation expense on computer equipment decreased in
2008.  Depreciation expense on furniture and equipment was $386,000 in
2008, compared to $414,000 in 2007, a decrease of $28,000, or
6.76%.





For
comparison, furniture and equipment expense increased in 2007 to $508,000, or
4.96%, compared to 2006 at $484,000. The increase in 2007 was associated with
increased depreciation expense incurred.  Flooding occurred in the
region in June 2006, and significant damages were experienced as a
result.  Six of the Company’s twelve offices were affected and as
such, unexpected investment was made in new furniture and
equipment.  Much of the furniture and equipment replaced was older,
and in some cases, fully depreciated.  The new furniture and equipment
booked in 2006 caused the related depreciation expense to increase
significantly.  Depreciation expense on furniture and equipment was
$414,000 in 2007, compared to $392,000 in 2006, an increase of $22,000, or
5.61%.





FDIC
insurance and assessments were $227,000 in 2008 which compares to $151,000 in
2007, an increase of $76,000, or 50.33%. The increase is due to the new
risk-based deposit assessment system adopted by the FDIC beginning in 2007.
Under this system, all FDIC insured institutions are required to pay deposit
premiums. The additional premiums due were offset by credits issued for premiums
paid by the Company prior to 1996. Those credits for were fully depleted in the
first quarter of 2008.





For
comparison, FDIC insurance and assessments were $151,000 in 2007 which compared
to $127,000 in 2006, an increase of $24,000, or 18.90%.  The increase
in 2007 was also due to the new risk-based deposit assessment system adopted by
the FDIC beginning in 2007.





Professional
fees and outside services were $520,000 in 2008 which compares to $371,000 in
2007, an increase of $149,000, or 40.16%. This increase is not deemed to be
indicative of any trends as expenses were incurred in 2008 in the amount of
$70,000 which were not included in the budget. These costs were associated to
various consulting and review engagements as well as costs associated with the
Delaware companies. Professional fees and outside services were budgeted at
$377,000 for 2008.





For
comparison, professional fees and outside services were $371,000 in 2007 which
compared to $337,000 in 2006, an increase of $34,000, or 10.09%. The increase is
not considered material or the result of a trend. Loan review fees paid in
January 2007 in the amount of $12,000 which were not incurred in the same period
in 2006 were the reason for a substantial portion of the increase between
periods. Professional fees were budgeted at $330,000 for 2007.





Computer
services and supplies is another component of other expenses. This category
covers the expense of data processing for the Company.  In 2008, the
expense was $970,000 compared to $785,000 in 2007, an increase of $185,000, or
23.57%.  This increase is considered to be line with budget
expectations for 2008 as the Company works to implement new technologies to its
information technologies department.





For
comparison, in 2007, computer services and supplies were $785,000 compared to
$774,000 in 2006, an increase of $11,000, or 1.42%.  These costs were
in line with previous years’ expenditures.





Taxes,
other than payroll and income are a significant component of non-interest
expense. In 2008, this expense increased by $14,000, or 3.63%, to $400,000,
compared to 2007 which totaled $386,000.  This increase is not
considered to be significant and it should be noted that shares tax owed to
Pennsylvania will grow as a proportion of the overall growth in Company
assets.  The Company implemented a strategy in 2007 which will limit
this tax burden for future periods. The result of this strategy is evident based
on the limited increase in expense relative to the overall increase in assets in
2008.





For
comparison, taxes, other than payroll and income, increased in 2007, to
$386,000, compared to $370,000 in 2006, an increase of $16,000, or
4.32%.  In 2007, shares tax owed to Pennsylvania grew in proportion to
the overall growth in Company assets and this variance was in line with
expectations.









Amortization
expense-deposit acquisition premiums increased by $3,000, or 1.18%, to $258,000,
compared to 2007 at $255,000.  This increase is not deemed to be
material.


29


For
comparison, amortization expense-deposit acquisition premiums, decreased in
2007, to $255,000, compared to $299,000 in 2006, a decrease of $44,000, or
14.72%.  This decrease was due to the write-off of $38,000 of deposit
premiums in December of 2006. The subsequent elimination of monthly amortization
of those premiums accounts for the decrease in 2007.





Stationary
and printing supplies increased by $21,000, or 6.19%, to $360,000, compared to
2007 at $339,000.  This increase was within budget expectations for
2008.





For
comparison, stationary and printing supplies increased in 2007, to $339,000,
compared to $247,000 in 2006, an increase of $92,000, or 37.25%.  This
increase was due in part to a classification change in which certain computer
printing supplies were charged to stationary and printing supplies in 2007. In
previous years these expenses were charged to computer supplies. Additionally,
the Company has purchased equipment in relation to a remote deposit capture
system instituted in 2007. These charges are reflected in this
increase.





Every
other non-interest expense is in the category of other. In 2008, this expense
increased $244,000, or 14.87%, to $1,885,000. In 2008, the Company contracted
with an outside advertising firm to implement a more aggressive marketing and
promotional plan than in prior years. The program exceeded budget expectations
by $100,000 and the prior year marketing and promotional expenditures by
$157,000. Expectations for these expenses have been adjusted going
forward.





This
compares to 2007 when this expense decreased $37,000, or 2.21%, to
$1,641,000.  This decrease was deemed to be in line with budget
expectations.





FEDERAL INCOME
TAXES


The
provision for income taxes in 2008 was $87,000, compared to $1,097,000 in 2007
and $772,000 in 2006. The effective tax rate, which is the ratio of income tax
expense to income before taxes, was 3% in 2008, 18% in 2007, and 16% in 2006.
The tax rate for all periods was substantially less than the federal statutory
rate of 34% primarily due to tax-exempt securities and tax-exempt loan income
although 2008 does not compare to the previous two annual periods due to the
other-than-temporary security impairments recognized. As such, the effective tax
rate decreased in 2008 after increasing slightly in 2007 relative to 2006.
Please refer to Note 9 of the Notes to Consolidated Financial Statements
included as part of this report for further analysis of federal income tax
expense for 2008.





QUARTERLY RESULTS


Table 6
shows the quarterly results of operations for the Company for 2008 and
2007.  Interest income remained steady throughout
2008.  This was due primarily to loan balances which increased 8.45%
in 2008. This helped to offset market rates and rate moves by the Federal
Reserve Bank which cut the federal funds rate 425 basis points in
2008.





Interest
expense also remained steady throughout 2008 as increases to interest-bearing
deposit balances offset the series of rate cuts implemented by the Federal
Reserve Bank throughout 2008.  Many deposit accounts are tied to
indexes which reflect closely the short-end of the yield curve (Fed Funds) and
therefore, as rates go down, so does the resulting interest rate.





Increases
were made to the provision for  loan losses in 2008 due to deterioration in
real estate markets and the resulting drop in real estate values.





Table 6
shows that fluctuations were experienced in other-than-temporary security
impairments as well as gains and losses through sales of available-for-sale
securities in 2008 when compared to 2007.  This was due to activity in
the financial markets in which many investments saw there values plummet to
historic lows.




As a
result of the security impairments discussed above, the Company saw its earnings
per common share decrease somewhat significantly in the third quarter of
2008.




30


TABLE
6





Quarterly Results of
Operation


(In
Thousands, Except for Per Share Data)




Quarter
      Ended 200831-Mar
                                                        
                                                        
                                                        30-Jun
                                                        
                                                        
                                                        30-Sep
                                                        
                                                        
                                                        31-DecInterest
      Income
                                                        
                                                        $
                                                        6,411
                                                        
                                                        
                                                        $
                                                        6,308
                                                        
                                                        
                                                        $
                                                        6,323
                                                        
                                                        
                                                        $
                                                        6,437Interest
      Expense
                                                        
                                                        
                                                        2,434
                                                        
                                                        
                                                        
                                                        2,148
                                                        
                                                        
                                                        
                                                        2,156
                                                        
                                                        
                                                        
                                                        2,416Net
      Interest Income
                                                        
                                                        
                                                        3,977
                                                        
                                                        
                                                        
                                                        4,160
                                                        
                                                        
                                                        
                                                        4,167
                                                        
                                                        
                                                        
                                                        4,021Provision
      for Loan Losses
                                                        
                                                        
                                                        (120
                                                        )
                                                        
                                                        
                                                        (135
                                                        )
                                                        
                                                        
                                                        (165
                                                        )
                                                        
                                                        
                                                        (293
                                                        )Securities
      Gains/Losses
                                                        
                                                        
                                                        26
                                                        
                                                        
                                                        
                                                        (10
                                                        )
                                                        
                                                        
                                                        7
                                                        
                                                        
                                                        
                                                        105Other
      Than Temporary Impairment
                                                        
                                                        
                                                        (182
                                                        )
                                                        
                                                        
                                                        (83
                                                        )
                                                        
                                                        
                                                        (4,869
                                                        )
                                                        
                                                        
                                                        (122
                                                        )Other
      Income
                                                        
                                                        
                                                        754
                                                        
                                                        
                                                        
                                                        802
                                                        
                                                        
                                                        
                                                        866
                                                        
                                                        
                                                        
                                                        897Other
      Expense
                                                        
                                                        
                                                        (2,661
                                                        )
                                                        
                                                        
                                                        (2,514
                                                        )
                                                        
                                                        
                                                        (2,731
                                                        )
                                                        
                                                        
                                                        (2,771
                                                        )Income
      (Loss) Before taxes
                                                        
                                                        
                                                        1,794
                                                        
                                                        
                                                        
                                                        2,220
                                                        
                                                        
                                                        
                                                        (2,725
                                                        )
                                                        
                                                        
                                                        1,837Income
      Taxes (Benefit)
                                                        
                                                        
                                                        (379
                                                        )
                                                        
                                                        
                                                        (516
                                                        )
                                                        
                                                        
                                                        1,159
                                                        
                                                        
                                                        
                                                        (351
                                                        )Net
      (Loss) Income
                                                        
                                                        $
                                                        1,415
                                                        
                                                        
                                                        $
                                                        1,704
                                                        
                                                        
                                                        $
                                                        (1,566
                                                        )
                                                        
                                                        $
                                                        1,486Basic
      Earnings (Loss) per share
                                                        
                                                        
                                                        0.45
                                                        
                                                        
                                                        
                                                        0.55
                                                        
                                                        
                                                        
                                                        (0.50
                                                        )
                                                        
                                                        
                                                        0.47Diluted
      Earnings (Loss) per share
                                                        
                                                        
                                                        0.45
                                                        
                                                        
                                                        
                                                        0.55
                                                        
                                                        
                                                        
                                                        (0.50
                                                        )
                                                        
                                                        
                                                        0.47Quarter
      Ended 200731-Mar
                                                        
                                                        
                                                        30-Jun
                                                        
                                                        
                                                        30-Sep
                                                        
                                                        
                                                        31-DecInterest
      Income
                                                        
                                                        $
                                                        6,006
                                                        
                                                        
                                                        $
                                                        6,036
                                                        
                                                        
                                                        $
                                                        6,193
                                                        
                                                        
                                                        $
                                                        6,376Interest
      Expense
                                                        
                                                        
                                                        2,857
                                                        
                                                        
                                                        
                                                        2,807
                                                        
                                                        
                                                        
                                                        2,805
                                                        
                                                        
                                                        
                                                        2,636Net
      Interest Income
                                                        
                                                        
                                                        3,149
                                                        
                                                        
                                                        
                                                        3,229
                                                        
                                                        
                                                        
                                                        3,388
                                                        
                                                        
                                                        
                                                        3,740Provision
      for Loan Losses
                                                        
                                                        
                                                        (120
                                                        )
                                                        
                                                        
                                                        (120
                                                        )
                                                        
                                                        
                                                        (40
                                                        )
                                                        
                                                        
                                                        0Securities
      Gains/Losses
                                                        
                                                        
                                                        29
                                                        
                                                        
                                                        
                                                        (165
                                                        )
                                                        
                                                        
                                                        44
                                                        
                                                        
                                                        
                                                        (30
                                                        )Other
      Than Temporary Impairment
                                                        
                                                        
                                                        0
                                                        
                                                        
                                                        
                                                        0
                                                        
                                                        
                                                        
                                                        0
                                                        
                                                        
                                                        
                                                        0Other
      Income
                                                        
                                                        
                                                        772
                                                        
                                                        
                                                        
                                                        1,013
                                                        
                                                        
                                                        
                                                        783
                                                        
                                                        
                                                        
                                                        862Other
      Expense
                                                        
                                                        
                                                        (2,440
                                                        )
                                                        
                                                        
                                                        (2,471
                                                        )
                                                        
                                                        
                                                        (3,095
                                                        )
                                                        
                                                        
                                                        (2,560
                                                        )Income
      Before taxes
                                                        
                                                        
                                                        1,390
                                                        
                                                        
                                                        
                                                        1,486
                                                        
                                                        
                                                        
                                                        1,080
                                                        
                                                        
                                                        
                                                        2,012Income
      Taxes
                                                        
                                                        
                                                        (267
                                                        )
                                                        
                                                        
                                                        (197
                                                        )
                                                        
                                                        
                                                        (196
                                                        )
                                                        
                                                        
                                                        (437
                                                        )Net
      Income
                                                        
                                                        $
                                                        1,123
                                                        
                                                        
                                                        $
                                                        1,289
                                                        
                                                        
                                                        $
                                                        884
                                                        
                                                        
                                                        $
                                                        1,575Basic
      Earnings per share
                                                        
                                                        $
                                                        0.36
                                                        
                                                        
                                                        $
                                                        0.41
                                                        
                                                        
                                                        $
                                                        0.28
                                                        
                                                        
                                                        $
                                                        0.50Diluted
      Earnings per share
                                                        
                                                        $
                                                        0.36
                                                        
                                                        
                                                        $
                                                        0.41
                                                        
                                                        
                                                        $
                                                        0.28
                                                        
                                                        
                                                        $
                                                        0.50





RETURN ON AVERAGE ASSETS AND AVERAGE
EQUITY


Return on
average assets (ROA) measures the Company’s net income in relation to its total
average assets. The Company’s ROA for 2008 was 0.68%, compared to 1.17% in
2007.





Return on
average equity (ROE) indicates how effectively the Company can generate net
income on the capital invested by its stockholders. ROE is calculated by
dividing net income by average stockholders’ equity. The Company’s ROE for 2008
was 7.53%, compared to 11.85% for 2007.





FINANCIAL
CONDITION


The
Company’s financial condition can be evaluated in terms of trends in its sources
and uses of funds. The following table illustrates how the Company has managed
its sources and uses of funds that are directly affected by outside economic
factors, such as interest rate fluctuations:


31




TABLE
7





Sources, Uses of
Funds


(Dollars
In Thousands)




2008
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                2007
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                2006Average
                                                                                                                
                                                                                                                
                                                                                                                Increase/(Decrease)
                                                                                                                
                                                                                                                
                                                                                                                Average
                                                                                                                
                                                                                                                
                                                                                                                Increase/(Decrease)
                                                                                                                
                                                                                                                
                                                                                                                AverageFunding
      Uses
                                                                                                                
                                                                                                                Balance
                                                                                                                
                                                                                                                
                                                                                                                Amount
                                                                                                                
                                                                                                                
                                                                                                                Percent
                                                                                                                
                                                                                                                
                                                                                                                Balance
                                                                                                                
                                                                                                                
                                                                                                                Amount
                                                                                                                
                                                                                                                
                                                                                                                Percent
                                                                                                                
                                                                                                                
                                                                                                                BalanceReal
      Estate Loans
                                                                                                                
                                                                                                                $
                                                                                                                117,635
                                                                                                                
                                                                                                                
                                                                                                                $
                                                                                                                2,145
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                1.86
                                                                                                                %
                                                                                                                
                                                                                                                $
                                                                                                                115,490
                                                                                                                
                                                                                                                
                                                                                                                $
                                                                                                                4,518
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                4.07
                                                                                                                %
                                                                                                                
                                                                                                                $
                                                                                                                110,972Consumer
      Loans
                                                                                                                
                                                                                                                
                                                                                                                16,815
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (328
                                                                                                                )
                                                                                                                
                                                                                                                
                                                                                                                (1.91
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                17,143
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (67
                                                                                                                )
                                                                                                                
                                                                                                                
                                                                                                                (0.39
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                17,210Commercial
      Loans
                                                                                                                
                                                                                                                
                                                                                                                140,903
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                17,049
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                13.77
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                123,854
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                4,950
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                4.16
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                118,904Tax
      Exempt Loans
                                                                                                                
                                                                                                                
                                                                                                                22,913
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                1,748
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                8.26
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                21,165
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                1,114
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                5.56
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                20,051Other
      Loans
                                                                                                                
                                                                                                                
                                                                                                                469
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                2
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                0.43
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                467
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (6
                                                                                                                )
                                                                                                                
                                                                                                                
                                                                                                                (1.27
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                473Total
      Loans
                                                                                                                
                                                                                                                
                                                                                                                298,735
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                20,616
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                7.41
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                278,119
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                10,509
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                3.93
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                267,610Less
      Allowance for Loan Loss
                                                                                                                
                                                                                                                
                                                                                                                (2,599
                                                                                                                )
                                                                                                                
                                                                                                                
                                                                                                                (574
                                                                                                                )
                                                                                                                
                                                                                                                
                                                                                                                28.35
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                (2,025
                                                                                                                )
                                                                                                                
                                                                                                                
                                                                                                                319
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (2,344
                                                                                                                )Total
      Loans with Loan Loss
                                                                                                                
                                                                                                                
                                                                                                                296,136
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                20,042
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                7.26
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                276,094
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                10,828
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                4.08
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                265,266Taxable
      Securities
                                                                                                                
                                                                                                                
                                                                                                                67,897
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                2,459
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                3.76
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                65,438
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                236
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                0.36
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                65,202Non-Taxable
      Securities
                                                                                                                
                                                                                                                
                                                                                                                42,859
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (1,333
                                                                                                                )
                                                                                                                
                                                                                                                
                                                                                                                (3.02
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                44,192
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                4,757
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                12.06
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                39,435Total
      Securities
                                                                                                                
                                                                                                                
                                                                                                                110,756
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                1,126
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                1.03
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                109,630
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                4,993
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                4.77
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                104,637Time
      Deposit with Other Banks
                                                                                                                
                                                                                                                
                                                                                                                1,186
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                871
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                276.51
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                315
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (617
                                                                                                                )
                                                                                                                
                                                                                                                
                                                                                                                (66.20
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                932Fed
      Funds Sold
                                                                                                                
                                                                                                                
                                                                                                                6,817
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                6,094
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                842.88
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                723
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (1,744
                                                                                                                )
                                                                                                                
                                                                                                                
                                                                                                                (70.69
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                2,467Total
      Uses
                                                                                                                
                                                                                                                $
                                                                                                                414,895
                                                                                                                
                                                                                                                
                                                                                                                $
                                                                                                                28,133
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                7.27
                                                                                                                %
                                                                                                                
                                                                                                                $
                                                                                                                386,762
                                                                                                                
                                                                                                                
                                                                                                                $
                                                                                                                13,460
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                3.61
                                                                                                                %
                                                                                                                
                                                                                                                $
                                                                                                                373,3022008
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                2007
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                2006Average
                                                                                                                
                                                                                                                
                                                                                                                Increase/(Decrease)
                                                                                                                
                                                                                                                
                                                                                                                Average
                                                                                                                
                                                                                                                
                                                                                                                Increase/(Decrease)
                                                                                                                
                                                                                                                
                                                                                                                AverageFunding
      Sources
                                                                                                                
                                                                                                                Balance
                                                                                                                
                                                                                                                
                                                                                                                Amount
                                                                                                                
                                                                                                                
                                                                                                                Percent
                                                                                                                
                                                                                                                
                                                                                                                Balance
                                                                                                                
                                                                                                                
                                                                                                                Amount
                                                                                                                
                                                                                                                
                                                                                                                Percent
                                                                                                                
                                                                                                                
                                                                                                                BalanceInterest
      Bearing Demand Deposits
                                                                                                                
                                                                                                                $
                                                                                                                28,871
                                                                                                                
                                                                                                                
                                                                                                                $
                                                                                                                3,530
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                13.93
                                                                                                                %
                                                                                                                
                                                                                                                $
                                                                                                                25,341
                                                                                                                
                                                                                                                
                                                                                                                $
                                                                                                                (121
                                                                                                                )
                                                                                                                
                                                                                                                
                                                                                                                (0.48
                                                                                                                )%
                                                                                                                
                                                                                                                $
                                                                                                                25,462Regular
      Savings Deposits
                                                                                                                
                                                                                                                
                                                                                                                94,019
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (12,950
                                                                                                                )
                                                                                                                
                                                                                                                
                                                                                                                (12.11
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                106,969
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                11,609
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                12.17
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                95,360Money
      Market Savings Deposits
                                                                                                                
                                                                                                                
                                                                                                                33,858
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (1,497
                                                                                                                )
                                                                                                                
                                                                                                                
                                                                                                                (4.23
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                35,355
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (2,392
                                                                                                                )
                                                                                                                
                                                                                                                
                                                                                                                (6.34
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                37,747Time
      Deposits
                                                                                                                
                                                                                                                
                                                                                                                132,313
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                29,670
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                28.91
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                102,643
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                448
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                0.44
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                102,195Total
      Interest Bearing Deposits
                                                                                                                
                                                                                                                
                                                                                                                289,061
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                18,753
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                6.94
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                270,308
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                9,544
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                3.66
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                260,764Other
      BorrowingsShort-Term
      Funds Borrowed
                                                                                                                
                                                                                                                
                                                                                                                16,876
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                4,747
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                39.14
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                12,129
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (474
                                                                                                                )
                                                                                                                
                                                                                                                
                                                                                                                (3.76
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                12,603Long-Term
      Funds Borrowed
                                                                                                                
                                                                                                                
                                                                                                                41,492
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                3,438
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                9.03
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                38,054
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                1,779
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                4.90
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                36,275Total
      Funds Borrowed
                                                                                                                
                                                                                                                
                                                                                                                58,368
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                8,185
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                16.31
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                50,183
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                1,305
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                2.67
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                48,878T Total
      Deposits and Funds Borrowed
                                                                                                                
                                                                                                                
                                                                                                                347,429
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                26,938
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                8.41
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                320,491
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                10,849
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                3.50
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                309,642Other
      Sources, net
                                                                                                                
                                                                                                                
                                                                                                                67,466
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                1,195
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                1.80
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                66,271
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                2,611
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                4.10
                                                                                                                %
                                                                                                                
                                                                                                                
                                                                                                                63,660Total
      Sources
                                                                                                                
                                                                                                                $
                                                                                                                414,895
                                                                                                                
                                                                                                                
                                                                                                                $
                                                                                                                28,133
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                7.27
                                                                                                                %
                                                                                                                
                                                                                                                $
                                                                                                                386,762
                                                                                                                
                                                                                                                
                                                                                                                $
                                                                                                                13,460
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                3.61
                                                                                                                %
                                                                                                                
                                                                                                                $
                                                                                                                373,302


32




Total
Sources of funds were up $28,133,000 in average balances for 2008 which is a
7.27% increase. The primary source of the increase was in time deposits with an
increase of $29,670,000 or 28.91%. Savings Deposits ended the 2008 year with an
average balance of $94,019,000 compared to $106,969,000 in 2007, a decrease of
$12,950,000 or 12.11%.  Borrowed Funds were up $8,185,000 or 16.31%
ending the year with an average balance of $58,368,000 compared to an average
balance of $50,183,000 for 2007 and an average balance of $48,878,000 for 2006.
In 2008, the Company experienced significant deposit growth from its customer
base in relation to natural gas lease contracts. At the same time, short term
funding rates were falling significantly based on actions of the Federal
Reserve. The Company managed to retain and grow deposits by offering higher
rate, short-term time deposits that satisfied customer needs without undue
strain to its net interest margin.





On the
Asset side, the increase in funding was used to fill loan demand. The average
balance in loans less the loan loss allowance for 2008 was $296,136,000 compared
to an average balance of $276,094,000 in 2007 and $265,266,000 in
2006.  Real estate loans were $2,145,000 or 1.86% higher in average
balance in 2008 averaging $117,635,000 compared to an average balance of
$115,490,000 in 2007. Commercial loans were up significantly in 2008 ending the
year with an average balance of $140,903,000 which is an increase of $17,049,000
or 13.77% over the 2007 average balance of $123,854,000.  Securities
ended the 2008 year with an average balance of $110,756,000 compared to
$109,630,000 million in 2007, an increase of $1,126,000 or 1.03%.





Loan Portfolio
Types


In 2008,
loans to commercial borrowers helped fuel the growth in net loans. Residential
mortgage loans increased only slightly with lower interest rates and mortgage
finance companies making growth in this part of our loan portfolio
tougher.





TABLE
8





Loan
Portfolio


(In
Thousands)


December
      31,2008
                                          
                                          
                                          2007
                                          
                                          
                                          2006
                                          
                                          
                                          2005
                                          
                                          
                                          2004Commercial
                                          
                                          $
                                          178,342
                                          
                                          
                                          $
                                          155,796
                                          
                                          
                                          $
                                          140,931
                                          
                                          
                                          $
                                          132,054
                                          
                                          
                                          $
                                          119,641Residential
      Real Estate Mortgage
                                          
                                          
                                          120,813
                                          
                                          
                                          
                                          116,922
                                          
                                          
                                          
                                          112,883
                                          
                                          
                                          
                                          109,034
                                          
                                          
                                          
                                          106,454Consumer
                                          
                                          
                                          16,988
                                          
                                          
                                          
                                          17,889
                                          
                                          
                                          
                                          16,947
                                          
                                          
                                          
                                          17,780
                                          
                                          
                                          
                                          18,375Total
      Loans
                                          
                                          
                                          316,143
                                          
                                          
                                          
                                          290,607
                                          
                                          
                                          
                                          270,761
                                          
                                          
                                          
                                          258,868
                                          
                                          
                                          
                                          244,470Deferred
      Loan Fees and Costs
                                          
                                          
                                          465
                                          
                                          
                                          
                                          445
                                          
                                          
                                          
                                          414
                                          
                                          
                                          
                                          377
                                          
                                          
                                          
                                          344Total
      Loans, net of Deferred
                                          
                                          
                                          316,608
                                          
                                          
                                          $
                                          291,052
                                          
                                          
                                          $
                                          271,175
                                          
                                          
                                          $
                                          259,245
                                          
                                          
                                          
                                          244,814Allowance
      for Loan Loss
                                          
                                          
                                          (3,002
                                          )
                                          
                                          
                                          (2,451
                                          )
                                          
                                          
                                          (1,792
                                          )
                                          
                                          
                                          (2,375
                                          )
                                          
                                          
                                          (2,739
                                          )Net
      Loans
                                          
                                          $
                                          313,606
                                          
                                          
                                          $
                                          288,601
                                          
                                          
                                          $
                                          269,383
                                          
                                          
                                          $
                                          256,870
                                          
                                          
                                          $
                                          242,075





Loans
continued to increase in 2008, ending the year with $313,606,000 in net loans
compared to $288,601,000 at year-end 2007, an increase of 8.66%. Commercial
loans grew 14.47% to close the year at $178,342,000, compared to $155,796,000 at
year-end 2007.





Residential
mortgages were up 3.33% to $120,813,000, compared to $116,922,000 on December
31, 2007 an increase of $3,891,000. Although our mortgage portfolio grew
modestly in 2008, there was an additional $6,391,000 mortgage loans sold to
Fannie Mae and FHLB.  The Bank will continue to sell mortgages on the
secondary market in order to attract and retain mortgage loans by offering more
competitive rates and terms.





The
continued growth in commercial lending was due, in part, to a concerted effort
on our part to continue to increase our exposure to this business
segment.


33


Loan Maturities


Table 9
shows the breakdown in maturity and type of our loan portfolio, including
non-accrual loans.





The Bank
has 9.09% of its loans maturing within the next year. Of those maturing within
one year, the majority are commercial loans with the remainder split between
mortgages and consumer loans. In the one-to-five year maturity range, the Bank
has 22.61% of its loan portfolio maturing. The over-five-year maturity group
makes up 68.30% of the portfolio.





For
comparison, at December 31, 2007, the Bank had 9.31% of its loans maturing
within one year. Of those maturing within one year, the majority again were
commercial loans with the remainder split between mortgages and consumer loans.
In the one-to-five year maturity range, the Bank had 21.07% of its portfolio.
The over-five-year maturity group made up 69.62% of the portfolio.





TABLE
9




Loan Maturities


(In
Thousands)




One
      YearOr
      Less
                                              
                                              
                                              Over
      One YearWithin
      Five Years
                                              
                                              
                                              OverFive
      Years
                                              
                                              
                                              TotalLoansCommercial
                                              
                                              $
                                              18,888
                                              
                                              
                                              $
                                              42,014
                                              
                                              
                                              $
                                              117,440
                                              
                                              
                                              $
                                              178,342Real-Estate
      Construction
                                              
                                              
                                              0
                                              
                                              
                                              
                                              0
                                              
                                              
                                              
                                              0
                                              
                                              
                                              
                                              0Real-Estate
      Mortgage
                                              
                                              
                                              5,398
                                              
                                              
                                              
                                              21,865
                                              
                                              
                                              
                                              93,550
                                              
                                              
                                              
                                              120,813Installment
                                              
                                              
                                              4,436
                                              
                                              
                                              
                                              7,607
                                              
                                              
                                              
                                              4,945
                                              
                                              
                                              
                                              16,988Total
                                              
                                              $
                                              28,722
                                              
                                              
                                              $
                                              71,486
                                              
                                              
                                              $
                                              215,935
                                              
                                              
                                              $
                                              316,143Total
      Loans with Predetermined Rates
                                              
                                              $
                                              18,590
                                              
                                              
                                              $
                                              32,805
                                              
                                              
                                              $
                                              31,482
                                              
                                              
                                              $
                                              82,877Total
      Loans with Variable Rates
                                              
                                              
                                              10,132
                                              
                                              
                                              
                                              38,681
                                              
                                              
                                              
                                              184,453
                                              
                                              
                                              
                                              233,266Total
                                              
                                              $
                                              28,722
                                              
                                              
                                              $
                                              71,486
                                              
                                              
                                              $
                                              215,935
                                              
                                              
                                              $
                                              316,143





TABLE
10





Non-performing
Assets


(Dollars
In Thousands)


December
      31,2008
                                        
                                        
                                        2007
                                        
                                        
                                        2006
                                        
                                        
                                        2005
                                        
                                        
                                        2004Non-accrual
      and Restructured
                                        $
                                        4,871
                                        
                                        
                                        $
                                        395
                                        
                                        
                                        $
                                        445
                                        
                                        
                                        $
                                        1,105
                                        
                                        
                                        $
                                        2,063Loans
      Past Due 90 or More Days, Accruing Interest
                                        
                                        245
                                        
                                        
                                        
                                        91
                                        
                                        
                                        
                                        275
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        130Total
      Nonperforming Loans
                                        
                                        5,116
                                        
                                        
                                        
                                        486
                                        
                                        
                                        
                                        720
                                        
                                        
                                        
                                        1,105
                                        
                                        
                                        
                                        2,193Foreclosed
      Assets
                                        
                                        5,171
                                        
                                        
                                        
                                        4,675
                                        
                                        
                                        
                                        5,062
                                        
                                        
                                        
                                        117
                                        
                                        
                                        
                                        257Total
      Nonperforming Assets
                                        $
                                        10,287
                                        
                                        
                                        $
                                        5,161
                                        
                                        
                                        $
                                        5,782
                                        
                                        
                                        $
                                        1,222
                                        
                                        
                                        $
                                        2,450Nonperforming
      Loans to Total Loans at Period-end
                                        
                                        1.62
                                        %
                                        
                                        
                                        0.17
                                        %
                                        
                                        
                                        0.27
                                        %
                                        
                                        
                                        0.43
                                        %
                                        
                                        
                                        0.91
                                        %Nonperforming
      Assets to Period-end Loans and Foreclosed Assets
                                        
                                        3.20
                                        %
                                        
                                        
                                        1.75
                                        %
                                        
                                        
                                        2.10
                                        %
                                        
                                        
                                        0.47
                                        %
                                        
                                        
                                        1.01
                                        %Interest
      Income That Would Have Been Recorded on Non-Accrual Loans Under Original
      Terms
                                        $
                                        26
                                        
                                        
                                        $
                                        32
                                        
                                        
                                        $
                                        84
                                        
                                        
                                        $
                                        59
                                        
                                        
                                        $
                                        94Interest
      Income Recorded on Non-Accrual Loans During the Period
                                        $
                                        27
                                        
                                        
                                        $
                                        15
                                        
                                        
                                        $
                                        7
                                        
                                        
                                        $
                                        9
                                        
                                        
                                        $
                                        29Commitments
      To Lend Additional Funds on Non-Accrual and Restructured
    Loans
                                        $
                                        0
                                        
                                        
                                        $
                                        0
                                        
                                        
                                        $
                                        0
                                        
                                        
                                        $
                                        0
                                        
                                        
                                        $
                                        0





34


Allowance for Loan
Losses


The
balance in the allowance for loan losses is based on management’s assessment of
the risk in the loan portfolio. Allocations to specific commercial loans are
made in adherence to SFAS 114, Accounting by Creditors for Impairments of a
Loan. These allocations are based upon the present value of expected future cash
flows or the fair value of the underlying collateral. In addition, management
reviews the other components of the loan portfolio through the loan review
function and assigns internal grades to loans based upon the perceived risks
inherent in each loan. In that determination, management reviews a number of
factors including historical analysis of similar credits, delinquency reports,
ratio analysis as compared to peers, concentration of credit risks, local
economic conditions, and regulatory evaluation of the allowance for loan losses.
The allowance for loan losses is maintained at a level considered adequate to
provide for losses that can be reasonably anticipated.  Management’s
periodic evaluation of the adequacy of the allowance is based on the Bank’s past
loan loss experience, known or inherent risks in the portfolio, adverse
situations that may affect the borrower’s ability to repay, the estimated value
of any underlying collateral, composition of the loan portfolio, current
economic conditions and other relevant factors.  Management believed
that certain risks, primarily current economic conditions, warranted an increase
in the allowance for loan losses for the year ended December 31, 2008 and as
such, the Company allotted $713,000 for provision for loan losses in 2008. This
evaluation is reviewed monthly by management and by the Board of Directors.
Management believes that on December 31, 2008, the allowance for loan losses was
adequate to absorb potential losses in the loan portfolio. However, this
judgment is subjective and a significant degradation in loan quality could
require a change in the estimates and therefore, a change in net
income.





The
following is a summary of loans charged off, recoveries and provisions to the
allowance for loan losses for the periods presented.





TABLE
11





Summary of Loan Loss
Experience


(Dollars
In Thousands)


Year
      Ended, December 312008
                                                                                                                          
                                                                                                                          
                                                                                                                          2007
                                                                                                                          
                                                                                                                          
                                                                                                                          2006
                                                                                                                          
                                                                                                                          
                                                                                                                          2005
                                                                                                                          
                                                                                                                          
                                                                                                                          2004Average
      Total Loans
                                                                                                                          
                                                                                                                          $
                                                                                                                          298,735
                                                                                                                          
                                                                                                                          
                                                                                                                          $
                                                                                                                          278,119
                                                                                                                          
                                                                                                                          
                                                                                                                          $
                                                                                                                          267,610
                                                                                                                          
                                                                                                                          
                                                                                                                          $
                                                                                                                          250,559
                                                                                                                          
                                                                                                                          
                                                                                                                          $
                                                                                                                          241,037Balance
      at Beginning of Period
                                                                                                                          
                                                                                                                          $
                                                                                                                          2,451
                                                                                                                          
                                                                                                                          
                                                                                                                          $
                                                                                                                          1,792
                                                                                                                          
                                                                                                                          
                                                                                                                          $
                                                                                                                          2,375
                                                                                                                          
                                                                                                                          
                                                                                                                          $
                                                                                                                          2,739
                                                                                                                          
                                                                                                                          
                                                                                                                          $
                                                                                                                          2,093Charge
      OffsCommercial
                                                                                                                          
                                                                                                                          
                                                                                                                          142
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          0
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          797
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          633
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          335Residential
      Real Estate
                                                                                                                          
                                                                                                                          
                                                                                                                          4
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          0
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          21
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          31
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          0Installment
                                                                                                                          
                                                                                                                          
                                                                                                                          100
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          73
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          98
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          129
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          108Total
      Charge Offs
                                                                                                                          
                                                                                                                          
                                                                                                                          246
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          73
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          916
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          793
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          443RecoveriesCommercial
                                                                                                                          
                                                                                                                          
                                                                                                                          44
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          422
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          5
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          0
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          12Residential
      Real Estate
                                                                                                                          
                                                                                                                          
                                                                                                                          2
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          3
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          5
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          0
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          0Installment
                                                                                                                          
                                                                                                                          
                                                                                                                          38
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          27
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          21
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          37
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          27Total
      Recoveries
                                                                                                                          
                                                                                                                          
                                                                                                                          84
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          452
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          31
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          37
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          39Net
      Charge-Offs (Recoveries)
                                                                                                                          
                                                                                                                          
                                                                                                                          162
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          (379
                                                                                                                          )
                                                                                                                          
                                                                                                                          
                                                                                                                          885
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          756
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          404Provision
      for Loan Losses
                                                                                                                          
                                                                                                                          
                                                                                                                          713
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          280
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          302
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          392
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          1050Balance
      at End of Period
                                                                                                                          
                                                                                                                          $
                                                                                                                          3,002
                                                                                                                          
                                                                                                                          
                                                                                                                          $
                                                                                                                          2,451
                                                                                                                          
                                                                                                                          
                                                                                                                          $
                                                                                                                          1,792
                                                                                                                          
                                                                                                                          
                                                                                                                          $
                                                                                                                          2,375
                                                                                                                          
                                                                                                                          
                                                                                                                          $
                                                                                                                          2,739Allowance
      for Loan Losses to Period-end Total Loans
                                                                                                                          
                                                                                                                          
                                                                                                                          0.95
                                                                                                                          %
                                                                                                                          
                                                                                                                          
                                                                                                                          0.84
                                                                                                                          %
                                                                                                                          
                                                                                                                          
                                                                                                                          0.66
                                                                                                                          %
                                                                                                                          
                                                                                                                          
                                                                                                                          0.92
                                                                                                                          %
                                                                                                                          
                                                                                                                          
                                                                                                                          1.12
                                                                                                                          %Allowance
      for Loan Losses to Non-accrual Loans
                                                                                                                          
                                                                                                                          
                                                                                                                          498.67
                                                                                                                          %
                                                                                                                          
                                                                                                                          
                                                                                                                          620.51
                                                                                                                          %
                                                                                                                          
                                                                                                                          
                                                                                                                          402.70
                                                                                                                          %
                                                                                                                          
                                                                                                                          
                                                                                                                          206.62
                                                                                                                          %
                                                                                                                          
                                                                                                                          
                                                                                                                          132.77
                                                                                                                          %Net
      Charge-Offs (Recoveries) to Average Loans
                                                                                                                          
                                                                                                                          
                                                                                                                          .05
                                                                                                                          %
                                                                                                                          
                                                                                                                          
                                                                                                                          (0.14
                                                                                                                          %)
                                                                                                                          
                                                                                                                          
                                                                                                                          0.33
                                                                                                                          %
                                                                                                                          
                                                                                                                          
                                                                                                                          0.29
                                                                                                                          %
                                                                                                                          
                                                                                                                          
                                                                                                                          0.17
                                                                                                                          %


35




TABLE
12





The
following table details the allocation of the allowance for loan losses to
various categories:




Allocation
of Allowance
 (Dollars
In Thousands)


Dec
      2008
                                        
                                        
                                        %
      of Loan Type
                                          to
      Total Loans
                                        
                                        
                                        Dec
      2007
                                        
                                        
                                        %
      of Loan Type
                                          to
      Total Loans
                                        
                                        
                                        Dec
      2006
                                        
                                        
                                        %
      of Loan Type
                                          to
      Total LoansCommercial
                                        
                                        $
                                        1,598
                                        
                                        
                                        
                                        56.33
                                        %
                                        
                                        $
                                        1,428
                                        
                                        
                                        
                                        53.70
                                        %
                                        
                                        $
                                        1,429
                                        
                                        
                                        
                                        52.05
                                        %Real
      Estate Mortgage
                                        
                                        
                                        627
                                        
                                        
                                        
                                        38.29
                                        %
                                        
                                        
                                        738
                                        
                                        
                                        
                                        40.15
                                        %
                                        
                                        
                                        274
                                        
                                        
                                        
                                        41.69
                                        %Consumer
                                        
                                        
                                        153
                                        
                                        
                                        
                                        5.38
                                        %
                                        
                                        
                                        285
                                        
                                        
                                        
                                        6.15
                                        %
                                        
                                        
                                        89
                                        
                                        
                                        
                                        6.26
                                        %Non
      Performing
                                        
                                        
                                        624
                                        
                                        
                                        
                                        N/A
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        N/A
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        N/ATotal
      Allowance for Loan Losses
                                        
                                        $
                                        3,002
                                        
                                        
                                        
                                        100.00
                                        %
                                        
                                        $
                                        2,451
                                        
                                        
                                        
                                        100.00
                                        %
                                        
                                        $
                                        1,792
                                        
                                        
                                        
                                        100.00
                                        %




Dec
      2005
              
              
              %
      of Loan Type
                to
      Total loans
              
              
              Dec
      2004
              
              
              %
      of Loan Type
                to
      Total LoansCommercial
              
              $
              2,035
              
              
              
              58.56
              %
              
              $
              2,366
              
              
              
              48.94
              %Real
      Estate Mortgage
              
              
              286
              
              
              
              38.11
              %
              
              
              272
              
              
              
              43.54
              %Consumer
              
              
              54
              
              
              
              3.33
              %
              
              
              101
              
              
              
              7.52
              %Non
      Performing
              
              
              0
              
              
              
              N/A
              
              
              
              0
              
              
              
              N/ATotal
      Allowance for Loan Losses
              
              $
              2,375
              
              
              
              100.00
              %
              
              $
              2,739
              
              
              
              100.00
              %





Management
believes the allowance is adequate to cover the inherent risks associated with
the loan portfolio. While allocations have been established for particular loan
categories, management considers the entire allowance to be available to absorb
losses in any category.





SECURITIES


The
Company’s securities portfolio is classified, in its entirety, as
“available-for-sale” as shown in Table 13. Management believes that a portfolio
classification of all available-for-sale allows complete flexibility in the
investment portfolio. Using this classification, the Company intends to hold
these securities for an indefinite amount of time but not necessarily to
maturity. Such securities are carried at fair value with the unrealized holding
gains or losses, net of taxes, reported as a component of the Company’s
stockholders’ equity on the balance sheet. The portfolio is structured to
provide maximum return on investments while providing a consistent source of
liquidity and meeting strict risk standards.





Securities
available-for-sale decreased by $2,499,000 in 2008. The securities
available-for-sale portfolio is comprised of U.S. Government Agency securities,
mortgage-backed securities, high-grade municipal securities, corporate-debt
securities, and equity securities. At December 31, 2008, the unrealized loss on
securities available-for-sale included in stockholders’ equity totaled
$4,755,000, net of tax, compared to unrealized losses of $1,390,000, net of tax,
at December 31, 2007. The weighted-average maturity of the securities
available-for-sale portfolio was ten years at December 31, 2008, with a
weighted-average yield of 4.65%.





At
December 31, 2008, the Company had 74 obligations of state and political
subdivisions, 10 mortgage-backed securities, 13 corporate debt securities, 2
preferred equity securities, and 14 common equity securities in an unrealized
loss position.


36


At
December 31, 2008, 14 common equity securities had totaled unrealized losses of
$327,000.  These securities have traditionally been high-performing
stocks.  As a result of recent market volatility in financial stocks
from news of sub-prime lending problems, as well as concerns surrounding the
financial markets, liquidity and credit availability, the fair value of most of
the stocks held are “under water” as of December 31, 2008, and as such, are
considered to be impaired.  The Company does not invest in bank stocks
with the intent to turn them over for a profit in the near-term.  We
invest in those stocks that we believe to have potential to appreciate in value
over the long-term, while providing for a reasonable dividend
yield.  We buy and hold those stocks that we believe have potential to
be an acquirer or to be acquired, providing additional value.  Stocks
can be cyclical in nature and will experience some down
periods.  Historically, bank stocks have sustained cyclical losses,
followed by periods of substantial gains, therefore we believe that both
unrealized losses and gains are likely to be temporary, when observing
performance in the banking sector.





In
management’s opinion, the unrealized losses on all other securities reflect
changes in interest rates subsequent to the acquisition of specific
securities.  The Company has the intent and the ability to hold such
securities until maturity or market price recovery.  Management
believes that the unrealized losses represent temporary impairment of the
securities.





Reference
should be made to Note 14 of the consolidated financial statements for further
discussion of fair value. The fair value of the Company’s securities portfolio
is classified as Level 1, Level 2 or Level 3. Level 1 inputs are derived from
quoted prices within active markets for such securities.  The Company
currently holds securities at Level 1 fair values of $1,010,000. Level 2 inputs
are derived from quoted prices in inactive markets or from other observable
inputs. The Company holds securities at Level 2 fair values of $108,146,000.
Finally, Level 3 inputs are unobservable and based on little or no market
activity. Level 3 securities with a fair value of $1,091,000 are currently held
by the Company. Level 3 assets include impaired loans valued at $2,168,000 in
addition to Level 3 securities held by the Company. Fair value is defined as the
exit price, or how much the Company would receive in an orderly transaction
(sale) of the asset.





Level 1
securities held by the Company consist of the 14 aforementioned equity
positions. The fair value of these equity positions is based on quoted prices
received from the broker which are indicative of the most recent prices received
by sellers of those same positions in an active market.





Level 2
securities held by the Company are debt holdings from various market sectors.
The largest sector represented is the municipal markets. The value of this
sector has been adversely affected from the downgrades placed on the municipal
insurers by the rating agencies. The second largest sector represented is
mortgage backed securities. This sector has seen the affects of the overall
downturn in real estate in much of the nation. While the Company has not
participated in the sub-prime mortgage arena, the overall value of this type of
security has deteriorated due to market perceptions of liquidity and credit
availability. The Company receives pricing for its debt holdings from a third
party bond accounting service. The service evaluates pricing using a combination
of data from vendors, internal pricing models as well as assistance from their
own fixed income analysts and traders. From these multiple sources, the most
accurate price is determined and utilized in fair value reporting.





Level 3
securities held by the Company represent an equity holding in a closely held
company and impaired loans held by the Company for which there is not an active
market. The equity holding is inactive from a market stand point. For this
equity position, the Company relies on a specific broker quote. The fair value
of this equity position has not traditionally experienced wide
swings.   The impaired loan value is based on an independent
outside appraisal performed on the underlying real estate
collateral.


37


Table 13
shows the amortized cost and average yield of securities by maturity or call
date at December 31, 2008.  Since the below table is by maturity or
call date, it will not match the maturity schedule in the 2008 consolidated
financial statements Note 2, which is done by contractual maturity.





TABLE
13





Securities
by Maturities


(Amortized
Cost)


(Dollars
In Thousands)


1
      Year or Less
                                                        
                                                        
                                                        
                                                        1-5
      Years
                                                        
                                                        
                                                        
                                                        5-10
      Years
                                                        
                                                        
                                                        
                                                        Over
      10 Years
                                                        
                                                        
                                                        
                                                        TotalAverage
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        Average
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        Average
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        Average
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        AverageBalance
                                                        
                                                        Yield
                                                        
                                                        
                                                        
                                                        Balance
                                                        
                                                        Yield
                                                        
                                                        
                                                        
                                                        Balance
                                                        
                                                        Yield
                                                        
                                                        
                                                        
                                                        Balance
                                                        
                                                        Yield
                                                        
                                                        
                                                        
                                                        Balance
                                                        
                                                        YieldUS
      Government Agency
                                                        $
                                                        0
                                                        
                                                        
                                                        0.00
                                                        %
                                                        
                                                        
                                                        $
                                                        6,497
                                                        
                                                        
                                                        4.07
                                                        %
                                                        
                                                        
                                                        $
                                                        0
                                                        
                                                        
                                                        0.00
                                                        %
                                                        
                                                        
                                                        $
                                                        1,394
                                                        
                                                        
                                                        5.85
                                                        %
                                                        
                                                        
                                                        $
                                                        7,891
                                                        
                                                        
                                                        4.38
                                                        %State/County/Municipal
      Obligations
                                                        
                                                        1,857
                                                        
                                                        
                                                        3.50
                                                        %
                                                        
                                                        
                                                        
                                                        5,999
                                                        
                                                        
                                                        3.58
                                                        %
                                                        
                                                        
                                                        
                                                        11,255
                                                        
                                                        
                                                        4.08
                                                        %
                                                        
                                                        
                                                        
                                                        28,803
                                                        
                                                        
                                                        4.18
                                                        %
                                                        
                                                        
                                                        
                                                        47,914
                                                        
                                                        
                                                        4.06
                                                        %Taxable
      Municipals
                                                        
                                                        0
                                                        
                                                        
                                                        0.00
                                                        %
                                                        
                                                        
                                                        
                                                        753
                                                        
                                                        
                                                        5.50
                                                        %
                                                        
                                                        
                                                        
                                                        1,921
                                                        
                                                        
                                                        5.86
                                                        %
                                                        
                                                        
                                                        
                                                        492
                                                        
                                                        
                                                        5.79
                                                        %
                                                        
                                                        
                                                        
                                                        3,166
                                                        
                                                        
                                                        5.76
                                                        %Mortgage-Backed
      Securities
                                                        
                                                        2,899
                                                        
                                                        
                                                        5.24
                                                        %
                                                        
                                                        
                                                        
                                                        11,331
                                                        
                                                        
                                                        5.01
                                                        %
                                                        
                                                        
                                                        
                                                        6,124
                                                        
                                                        
                                                        5.63
                                                        %
                                                        
                                                        
                                                        
                                                        12,133
                                                        
                                                        
                                                        5.83
                                                        %
                                                        
                                                        
                                                        
                                                        32,487
                                                        
                                                        
                                                        5.45
                                                        %Corporate/Other
      Securities
                                                        
                                                        1,329
                                                        
                                                        
                                                        3.50
                                                        %
                                                        
                                                        
                                                        
                                                        4,927
                                                        
                                                        
                                                        5.76
                                                        %
                                                        
                                                        
                                                        
                                                        13,043
                                                        
                                                        
                                                        5.57
                                                        %
                                                        
                                                        
                                                        
                                                        1,529
                                                        
                                                        
                                                        1.47
                                                        %
                                                        
                                                        
                                                        
                                                        20,828
                                                        
                                                        
                                                        5.18
                                                        %Preferred
      Equity Securities
                                                        
                                                        0
                                                        
                                                        
                                                        0.00
                                                        %
                                                        
                                                        
                                                        
                                                        0
                                                        
                                                        
                                                        0.00
                                                        %
                                                        
                                                        
                                                        
                                                        0
                                                        
                                                        
                                                        0.00
                                                        %
                                                        
                                                        
                                                        
                                                        78
                                                        
                                                        
                                                        0.00
                                                        %
                                                        
                                                        
                                                        
                                                        78
                                                        
                                                        
                                                        0.00
                                                        %Common
      Equity Securities
                                                        
                                                        0
                                                        
                                                        
                                                        0.00
                                                        %
                                                        
                                                        
                                                        
                                                        0
                                                        
                                                        
                                                        0.00
                                                        %
                                                        
                                                        
                                                        
                                                        0
                                                        
                                                        
                                                        0.00
                                                        %
                                                        
                                                        
                                                        
                                                        5,086
                                                        
                                                        
                                                        2.73
                                                        %
                                                        
                                                        
                                                        
                                                        5,086
                                                        
                                                        
                                                        2.73
                                                        %Total Available-for-Sale
                                                        $
                                                        6,085
                                                        
                                                        
                                                        4.33
                                                        %
                                                        
                                                        
                                                        $
                                                        29,507
                                                        
                                                        
                                                        4.51
                                                        %
                                                        
                                                        
                                                        $
                                                        32,343
                                                        
                                                        
                                                        4.73
                                                        %
                                                        
                                                        
                                                        $
                                                        49,515
                                                        
                                                        
                                                        4.35
                                                        %
                                                        
                                                        
                                                        $
                                                        117,450
                                                        
                                                        
                                                        4.65
                                                        %




Table 14
shows the balance of securities for the past three years on December 31. More
details on securities can be found in Note 2 of the Consolidated Financial
Statements.





TABLE
14





Securities
(Fair Value)


(In
Thousands)


December
      31,2008
                                                                          
                                                                          
                                                                          2007
                                                                          
                                                                          
                                                                          2006U.
      S. Government/Agency Obligations
                                                                          
                                                                          $
                                                                          7,958
                                                                          
                                                                          
                                                                          $
                                                                          2,002
                                                                          
                                                                          
                                                                          $
                                                                          11,118State/Municipal
      Obligations
                                                                          
                                                                          
                                                                          44,715
                                                                          
                                                                          
                                                                          
                                                                          44,505
                                                                          
                                                                          
                                                                          
                                                                          30,338Taxable
      Municipal
                                                                          
                                                                          
                                                                          3,060
                                                                          
                                                                          
                                                                          
                                                                          1,994
                                                                          
                                                                          
                                                                          
                                                                          0Mortgage-backed
      Securities
                                                                          
                                                                          
                                                                          32,765
                                                                          
                                                                          
                                                                          
                                                                          45,168
                                                                          
                                                                          
                                                                          
                                                                          57,847Corporate
      Debt Securities
                                                                          
                                                                          
                                                                          16,970
                                                                          
                                                                          
                                                                          
                                                                          11,265
                                                                          
                                                                          
                                                                          
                                                                          3,257Preferred
      Equity Securities
                                                                          
                                                                          
                                                                          20
                                                                          
                                                                          
                                                                          
                                                                          1,841
                                                                          
                                                                          
                                                                          
                                                                          2,533Common
      Equity Securities
                                                                          
                                                                          
                                                                          4,759
                                                                          
                                                                          
                                                                          
                                                                          5,971
                                                                          
                                                                          
                                                                          
                                                                          5,209Total  Securities
      Available-for-Sale
                                                                          
                                                                          $
                                                                          110,247
                                                                          
                                                                          
                                                                          $
                                                                          112,746
                                                                          
                                                                          
                                                                          $
                                                                          110,302


38




DEPOSITS


Table 15
shows average deposits and other borrowings balances and rates for 2008, 2007
and 2006. The Company experienced growth of $18,753,000 in average interest
bearing deposits and $4,165,000 in average non-interest bearing deposits during
2008 compared to an increase of $9,544,000 in average interest bearing deposits
and $2,725,000 in average non-interest bearing deposits in
2007.  Average savings accounts decreased $12,950,000 in 2008 compared
to an increase of $11,609,000 during 2007. Management attributes the change in
the growth in this area to the increased popularity of certificates of deposit
as savings rates declined in 2008.  Average time deposits increased
$29,670,000 in 2008 compared to an increase of $448,000 in 2007 when compared to
2006.  In 2008, average other borrowings increased $8,185,000,
averaging $58,368,000 compared to the average balance of $50,183,000 in
2007.





TABLE
15





Average Deposits and Other
Borrowings


(Dollars
In Thousands)


2008
                                          
                                          
                                          2007
                                          
                                          
                                          2006Amount
                                          
                                          Rate
                                          
                                          
                                          Diff
      $
                                          
                                          
                                          Amount
                                          
                                          Rate
                                          
                                          
                                          Diff
      $
                                          
                                          
                                          Amount
                                          
                                          RateInterest
      Bearing Demand Deposits
                                          $
                                          28,871
                                          
                                          
                                          .98
                                          %
                                          
                                          $
                                          3,530
                                          
                                          
                                          $
                                          25,341
                                          
                                          
                                          1.14
                                          %
                                          
                                          $
                                          (121
                                          )
                                          
                                          $
                                          25,462
                                          
                                          
                                          1.03
                                          %Savings
      Deposits
                                          
                                          94,019
                                          
                                          
                                          1.30
                                          %
                                          
                                          
                                          (12,950
                                          )
                                          
                                          
                                          106,969
                                          
                                          
                                          3.10
                                          %
                                          
                                          
                                          11,609
                                          
                                          
                                          
                                          95,360
                                          
                                          
                                          3.29
                                          %Money
      Market Savings
                                          
                                          33,858
                                          
                                          
                                          1.77
                                          %
                                          
                                          
                                          (1,497
                                          )
                                          
                                          
                                          35,355
                                          
                                          
                                          3.08
                                          %
                                          
                                          
                                          (2,392
                                          )
                                          
                                          
                                          37,747
                                          
                                          
                                          3.83
                                          %Time
      Deposits
                                          
                                          132,313
                                          
                                          
                                          3.72
                                          %
                                          
                                          
                                          29,670
                                          
                                          
                                          
                                          102,643
                                          
                                          
                                          4.22
                                          %
                                          
                                          
                                          448
                                          
                                          
                                          
                                          102,195
                                          
                                          
                                          3.82
                                          %Total
      Interest Bearing Deposits
                                          
                                          289,061
                                          
                                          
                                          2.43
                                          %
                                          
                                          
                                          18,753
                                          
                                          
                                          
                                          270,308
                                          
                                          
                                          3.34
                                          %
                                          
                                          
                                          9,544
                                          
                                          
                                          
                                          260,764
                                          
                                          
                                          3.35
                                          %Other
      Borrowings
                                          
                                          58,368
                                          
                                          
                                          3.65
                                          %
                                          
                                          
                                          8,185
                                          
                                          
                                          
                                          50,183
                                          
                                          
                                          4.16
                                          %
                                          
                                          
                                          1,305
                                          
                                          
                                          
                                          48,878
                                          
                                          
                                          4.19
                                          %Total
      Interest Bearing Liabilities
                                          
                                          347,429
                                          
                                          
                                          2.63
                                          %
                                          
                                          
                                          26,938
                                          
                                          
                                          
                                          320,491
                                          
                                          
                                          3.46
                                          %
                                          
                                          
                                          10,849
                                          
                                          
                                          
                                          309,642
                                          
                                          
                                          3.49
                                          %Non-Interest
      Bearing Demand Deposits
                                          
                                          56,778
                                          
                                          
                                          
                                          
                                          
                                          
                                          4,165
                                          
                                          
                                          
                                          52,613
                                          
                                          
                                          
                                          
                                          
                                          
                                          2,725
                                          
                                          
                                          
                                          49,888Total
                                          $
                                          404,207
                                          
                                          
                                          2.26
                                          %
                                          
                                          $
                                          31,103
                                          
                                          
                                          $
                                          373,104
                                          
                                          
                                          2.98
                                          %
                                          
                                          $
                                          13,574
                                          
                                          
                                          $
                                          359,530
                                          
                                          
                                          3.01
                                          %





MATURITIES OF TIME
DEPOSITS


The
maturities on the time deposits of $100,000 and over are heavily distributed in
the three month or less category showing a concentration that could pose a
liquidity risk to the Bank. The concentration of short term certificates of
deposit are the result of lower savings interest rates and short term special
rates on certificates of deposit that came at a time in which the Bank was
experiencing a large influx of deposits from customers that had entered into
natural gas lease contracts. Management controls this risk through the monthly
monitoring procedures of the ALCO committee.  Table 16 shows the
dollar amount of large time deposits in each time category as well as the
overall percentage of each category.





TABLE
16





Maturities


(Dollars
In Thousands)


December
      31,2008Amount
                                                  
                                                  
                                                  PercentThree
      Months or Less
                                                  
                                                  $
                                                  28,913
                                                  
                                                  
                                                  
                                                  60.72
                                                  %Over
      Three Months through Six Months
                                                  
                                                  
                                                  9,654
                                                  
                                                  
                                                  
                                                  20.27
                                                  %Over
      Six Months through Twelve Months
                                                  
                                                  
                                                  2,554
                                                  
                                                  
                                                  
                                                  5.36
                                                  %Over
      Twelve Months
                                                  
                                                  
                                                  6,501
                                                  
                                                  
                                                  
                                                  13.65
                                                  %Total
                                                  
                                                  $
                                                  47,622
                                                  
                                                  
                                                  
                                                  100.00
                                                  %


39
  SHORT AND LONG-TERM
BORROWINGS


Short-term
borrowings, which are overnight or less than 30-day borrowings, consist of
securities sold under agreements to repurchase, Federal Home Loan Bank advances,
and U.S. Treasury tax and loan notes. Long-term borrowings consist of notes from
the Federal Home Loan Bank. These notes are secured under terms of a blanket
collateral agreement by a pledge of qualifying investment and mortgage-backed
securities, certain mortgage loans and a lien on FHLB stock. For more details on
short and long-term borrowings see Notes 6 and 7 of the Notes to Consolidated
Financial Statements.





TABLE
17





Borrowed
Funds


(In
Thousands)


December
      31,2008
                                        
                                        
                                        2007Short-Term
      Borrowings
                                        
                                        $
                                        18,432
                                        
                                        
                                        $
                                        22,848FHLB
      Long-Term Borrowings
                                        
                                        
                                        39,691
                                        
                                        
                                        
                                        38,534Total
                                        
                                        $
                                        58,123
                                        
                                        
                                        $
                                        61,382





CAPITAL
ACCOUNTS


Total
stockholders’ equity decreased 7.21%, or $3,085,000, from year-end 2007 to
finish at $39,720,000. A common ratio used to determine the effective use of
capital is the return on average equity. For the year ended December 31, 2008,
this ratio was 7.53%, compared to 11.38% at December 31, 2007. The Bank’s goal
is to maintain a strong capital position as well as to make the best use of
capital in the overall growth of the organization. At year-end 2008, the
equity-to-assets ratio was 8.41%, compared to 9.85% at year-end 2007. It is the
goal of management to implement ways to better leverage our capital with a
capital-to-assets ratio closer to 8%.





Compare
2008 results to those experienced in 2007 when total stockholders’ equity
increased 3.79% or $1,565,000 over year-end 2006. The return on average equity
for the year ended December 31, 2007 ratio was 11.38%, compared to
10.32% for the year ended December 31, 2006.  At year-end
2007, the equity-to-assets ratio was 9.85% compared to 9.91% at year-end
2006.





Net
income increased capital by $3,039,000 in 2008 and dividends decreased that
number by $2,417,000.  The adoption of the “Accounting for Deferred
Compensation and Postretirement Benefit Aspects of Endorsement Split Dollar Life
Insurance Arrangements” on January 1, 2008, decreased capital by
$71,000.  The securities portfolio decreased in value by $3,365,000,
net of tax in 2008. Since all of our securities are available-for-sale, changes
in market values adjusted for taxes are reflected in the equity portion of the
balance sheet.     A total of $272,000 in net treasury
stock issued reduced the capital account to equal the total net
change.  From time to time, the Company has purchased PFSC stock in
the open market or from individuals to leverage the capital account and to
provide stock for our dividend reinvestment plan and stock compensation plan.
During the year 2008, 20,000 shares were purchased in this manner. There were
12,688 shares issued from the treasury stock account by individuals exercising
options. The investment banking firms of Boenning & Scattergood
Inc. and Ryan Beck & Co. have been known to make markets in PFSC common
stock.





Net
income increased capital by $4,871,000 in 2007 and dividends reduced that number
by $2,383,000. The securities portfolio decreased in value by $995,000 in 2007.
Again, since all of our securities were available-for-sale, changes in market
values adjusted for taxes are reflected in the equity portion of the balance
sheet. A total of $69,000 in net treasury stock purchases increased the capital
account to equal the total net change.


40


The
following table represents the Company’s capital position as it compares to the
regulatory guidelines at December 31, 2008.





TABLE
18




Capital
Ratios


December
      31
                                                
                                                
                                                December
      31
                                                
                                                
                                                Regulatory2008
                                                
                                                
                                                2007
                                                
                                                
                                                RequirementTier
      1 capital to risk-weighted assets
                                                
                                                
                                                12.26
                                                %
                                                
                                                
                                                13.64
                                                %
                                                
                                                
                                                4.00
                                                %Total  capital
      to risk-weighted assets
                                                
                                                
                                                13.10
                                                %
                                                
                                                
                                                14.42
                                                %
                                                
                                                
                                                8.00
                                                %Tier
      1 capital to average assets-leverage ratio
                                                
                                                
                                                9.31
                                                %
                                                
                                                
                                                10.14
                                                %
                                                
                                                
                                                4.00
                                                %




INTEREST RATE
SENSITIVITY


The
operations of the Company do not subject it to foreign currency risk or
commodity price risk. The Company does not utilize interest rate swaps, caps, or
hedging transactions. In addition, the Company has no market risk sensitive
instruments entered into for trading purposes. However, the Company is subject
to interest rate risk and employs several different methods to manage and
monitor the risk.





Interest
rate sensitivity refers to the relationship between market interest rates and
the earnings volatility of the Company due to the repricing characteristics of
assets and liabilities. The responsibility for monitoring interest rate
sensitivity and policy decisions has been given to the Asset/Liability Committee
(ALCO) of the Bank. The tools used to monitor sensitivity are the Statement of
Interest Sensitivity Gap and the Interest Rate Shock Analysis. The Bank uses a
software model to measure and analyze interest rate risk. In addition, an
outside source completes a quarterly analysis to make sure our internal analysis
is current and correct. The Statement of Interest Sensitivity Gap is a good
assessment of current position and is a very useful tool for the ALCO in
performing its job. This report is monitored in an effort to “match” maturities
or repricing opportunities of assets and liabilities in order to attain the
maximum interest within risk tolerance policy guidelines. The statement does,
although, have inherent limitations in that certain assets and liabilities may
react to changes in interest rates in different ways with some categories
reacting in advance of changes and some lagging behind the changes. In addition,
there are estimates used in determining the actual propensity to change of
certain items such as deposits without maturities.




41


The
following sets forth the Company’s interest sensitivity analysis as of December
31, 2008:





TABLE
19





Statement of Interest Sensitivity
Gap


(Dollars
In Thousands)


Maturity
      or Repricing In:3
      Months
                                        
                                        
                                        3-6
      Months
                                        
                                        
                                        6-12
      Months
                                        
                                        
                                        1-5
      Years
                                        
                                        
                                        Over
      5 YearsRATE
      SENSITIVE ASSETSInterest
      Bearing Deposits With Other Banks
                                        
                                        $
                                        1,782
                                        
                                        
                                        $
                                        0
                                        
                                        
                                        $
                                        0
                                        
                                        
                                        $
                                        0
                                        
                                        
                                        $
                                        0Loans
                                        
                                        
                                        30,289
                                        
                                        
                                        
                                        21,100
                                        
                                        
                                        
                                        42,408
                                        
                                        
                                        
                                        160,831
                                        
                                        
                                        
                                        58,978Securities
                                        
                                        
                                        9,790
                                        
                                        
                                        
                                        7,046
                                        
                                        
                                        
                                        8,300
                                        
                                        
                                        
                                        30,031
                                        
                                        
                                        
                                        55,080Federal
      Funds Sold
                                        
                                        
                                        10,577
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        0Total
      Rate Sensitive Assets
                                        
                                        
                                        52,438
                                        
                                        
                                        
                                        28,146
                                        
                                        
                                        
                                        50,708
                                        
                                        
                                        
                                        190,862
                                        
                                        
                                        
                                        114,058Cumulative
      Rate Sensitive Assets
                                        
                                        
                                        52,438
                                        
                                        
                                        
                                        80,584
                                        
                                        
                                        
                                        131,292
                                        
                                        
                                        
                                        322,154
                                        
                                        
                                        
                                        436,212RATE
      SENSITIVE LIABILITIESInterest
      Bearing Checking
                                        
                                        
                                        30,276
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        0Money
      Market Deposits
                                        
                                        
                                        34,257
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        0Regular
      Savings
                                        
                                        
                                        87,106
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        0CDs
      and IRAs
                                        
                                        
                                        84,031
                                        
                                        
                                        
                                        34,149
                                        
                                        
                                        
                                        11,933
                                        
                                        
                                        
                                        30,852
                                        
                                        
                                        
                                        3,340Short-term
      Borrowings
                                        
                                        
                                        18,432
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        0Long-term
      Borrowings
                                        
                                        
                                        284
                                        
                                        
                                        
                                        216
                                        
                                        
                                        
                                        441
                                        
                                        
                                        
                                        26,456
                                        
                                        
                                        
                                        12,294Total
      Rate Sensitive Liabilities
                                        
                                        
                                        254,386
                                        
                                        
                                        
                                        34,365
                                        
                                        
                                        
                                        12,374
                                        
                                        
                                        
                                        57,308
                                        
                                        
                                        
                                        15,634Cumulative
      Rate Sensitive Liabilities
                                        
                                        $
                                        254,386
                                        
                                        
                                        $
                                        288,751
                                        
                                        
                                        $
                                        301,125
                                        
                                        
                                        $
                                        358,433
                                        
                                        
                                        $
                                        374,067Period
      Gap
                                        
                                        $
                                        (201,948
                                        )
                                        
                                        $
                                        (6,219
                                        )
                                        
                                        $
                                        38,334
                                        
                                        
                                        $
                                        133,554
                                        
                                        
                                        $
                                        98,424Cumulative
      Gap
                                        
                                        
                                        (201,948
                                        )
                                        
                                        
                                        (208,167
                                        )
                                        
                                        
                                        (169,833
                                        )
                                        
                                        
                                        (36,279
                                        )
                                        
                                        
                                        62,145Cumulative
      RSA to RSL
                                        
                                        
                                        20.61
                                        %
                                        
                                        
                                        27.91
                                        %
                                        
                                        
                                        43.60
                                        %
                                        
                                        
                                        89.88
                                        %
                                        
                                        
                                        116.61
                                        %Cumulative
      Gap to Total Assets
                                        
                                        
                                        (42.77
                                        )%
                                        
                                        
                                        (44.09
                                        )%
                                        
                                        
                                        (35.97
                                        )%
                                        
                                        
                                        (7.68
                                        )%
                                        
                                        
                                        13.16
                                        %





The Federal Reserve’s Open Market Committee (FOMC), dropped
rates aggressively by a total of 425 basis points in 2008.  This was
done in hopes of stemming the tide of negative economic events which began in
2007 with the sub-prime mortgage crisis and continued through 2008 as
foreclosure rates skyrocketed and home values plummeted. For the year ended
December 31, 2008, the overnight Fed Funds Rate was decreased a total of 425
basis points ending the year at a target rate of 0 to .25%.  The
effect of the easing has been a steep yield curve that has persisted throughout
2008.  The overall level of market rates dropped dramatically in 2008,
both on the short end and the long end of the curve.  The result of
this is that the net interest margin in 2008 increased to 4.25% when compared to
the net interest margin of 3.82% for the year ended December 31, 2007. The
increase to the net interest margin is the result of liability rates resetting
at historically low levels and reacting more swiftly to moves by the FOMC. The
asset side of the Company’s balance sheet has remained less reactive to rate
movements. While this has presented a positive opportunity to the Company in the
near-term, it also presents some challenges. As customers seek more competitive
rates on their deposits, the Company has remained diligent in offering deposit
alternatives for customers. This has helped to mitigate the loss of deposits to
competitors.





Compare
these results to 2007 when the Fed Funds rate was increased 100 basis points.
The result was a net interest margin that rose to 3.82% for the year ended
December 31, 2007 compared to 3.49% for the year ended December 31,
2006.


42


LIQUIDITY


The
liquidity of the Company is reflected in its capacity to have sufficient amounts
of cash available to fund the needs of customer withdrawal requests, accommodate
loan demand, and maintain regulatory reserve requirements; that is to conduct
banking business. Additional liquidity is obtained by either increasing
liabilities or by decreasing assets. The primary source for increasing
liabilities is the generation of additional deposit accounts, which are managed
through our system of branches. In addition, loan payments on existing loans or
investments available-for-sale can generate additional liquidity. Other sources
include income from operations, decreases in federal funds sold or
interest-bearing deposits in other banks, securities sold under agreements to
repurchase, and borrowings from the Federal Home Loan Bank (FHLB). On December
31, 2008, the Bank had a borrowing capacity from the Federal Home Loan Bank of
approximately $163,245,000.  During 2008, significant increases in
deposits has limited the Company’s dependence on overnight borrowings at the
Federal Home Loan Bank and provided the majority of additional cash with
operating activities also contributing to liquidity. The additional deposits
were used primarily to grant loans to customers.





As
evidenced by the sources (uses) of funds (table 7), maturity of large time
deposits (table 16), the interest rate sensitivity analysis (table 19) and the
list of contractual obligations (table 20 which follows this section), the
Company has increased its short term funding needs dramatically in 2008. This
was part of a strategic initiative based on a high demand for competitive rates
by deposit holders in a free-falling rate environment. This course of action was
made necessary in light of the large sums of money flowing into the region due
to natural gas drilling and exploration. Many of the Company’s customers were
the primary beneficiaries of those funds and the Company felt this was an
opportunity to expand current customer relationships as well as attract new
customers. As with all low rate environments however, customers were generally
unwilling to invest long term. Short term attractive rates were offered by the
Company and the result was a concentration in short term obligations. The
Company feels that it offers a variety of attractive deposit products at
competitive rates that will mitigate significant runoff in deposits from
occurring. One such product is the certificate of savings product which acts as
a hybrid between a core savings product and a short term certificate of deposit.
This deposit product offers an interest rate that far outweighs any comparable
savings product on the market and a quarterly limit placed on customer
withdrawals which provide stability in funding to the Company. This account has
proven to be a deposit leader in the past and the Company will rely on it to
provide a source of funds. Beyond its own product line up, the Company also has
available to it open lines of credit at the FHLB with current availability of
approximately $123,000,000, Atlantic Central Bankers Bank (ACBB) in the amount
of $7,000,000 and the Federal Reserve Bank of Philadelphia (FRB) that amount to
$1,500,000. While the FHLB has been an inexpensive source of funds in the past,
current liquidity concerns surrounding the FHLB have prompted the Company to
explore additional funding options at the FRB. Collateral standards of the FRB
make it feasible to increase available lines and open the Company up to yet
another source of funding liquidity. This will be investigated further and, if
deemed prudent, implemented in 2009.





The
following table represents the aggregate on-and-off balance sheet contractual
obligations to make future payments.





TABLE
20




Contractual
Obligations
 (In
Thousands)


December
      31, 2008Less
      than 1 year
                                                      
                                                      
                                                      1-3
      Years
                                                      
                                                      
                                                      4-5
      Years
                                                      
                                                      
                                                      Over
      5 Years
                                                      
                                                      
                                                      TotalTime
      Deposits
                                                      
                                                      $
                                                      130,113
                                                      
                                                      
                                                      $
                                                      14,605
                                                      
                                                      
                                                      $
                                                      16,247
                                                      
                                                      
                                                      $
                                                      3,340
                                                      
                                                      
                                                      $
                                                      164,305Long-term
      Debt
                                                      
                                                      
                                                      941
                                                      
                                                      
                                                      
                                                      9,823
                                                      
                                                      
                                                      
                                                      16,633
                                                      
                                                      
                                                      
                                                      12,294
                                                      
                                                      
                                                      
                                                      39,691Operating
      Leases
                                                      
                                                      
                                                      90
                                                      
                                                      
                                                      
                                                      175
                                                      
                                                      
                                                      
                                                      82
                                                      
                                                      
                                                      
                                                      564
                                                      
                                                      
                                                      
                                                      911Standby
      Letters of Credit
                                                      
                                                      
                                                      5,177
                                                      
                                                      
                                                      
                                                      82
                                                      
                                                      
                                                      
                                                      0
                                                      
                                                      
                                                      
                                                      0
                                                      
                                                      
                                                      
                                                      5,259$
                                                      136,321
                                                      
                                                      
                                                      $
                                                      24,685
                                                      
                                                      
                                                      $
                                                      32,962
                                                      
                                                      
                                                      $
                                                      16,198
                                                      
                                                      
                                                      $
                                                      210,166





The
Company is not aware of any known trends or any known demands, commitments,
events or uncertainties, which would result in any material increase or decrease
in liquidity beyond those already discussed.


43


OFF-BALANCE-SHEET
ARRANGEMENTS


The
financial statements do not reflect various off-balance sheet arrangements that
are made in the normal course of business, which may involve some liquidity
risk. These commitments consist mainly of unfunded loans and letters of credit
made under the same standards as on-balance-sheet instruments. Unused
commitments, at December 31, 2008, totaled $44,838,000. Because these
instruments have fixed maturity dates, and because many of them will expire
without being drawn upon, they do not generally present any significant
liquidity risk. Management believes that any amounts actually drawn upon can be
funded in the normal course of operations.





The
Company has no investment in or financial relationship with any unconsolidated
entities that are even remotely likely to have a material effect on liquidity or
the availability of capital resources.





SUBSEQUENT EVENTS


NONE





EFFECTS OF
INFLATION


The
majority of assets and liabilities of a financial institution are monetary in
nature and, therefore, differ greatly from commercial and industrial companies
that have significant investments in fixed assets or inventories. The precise
impact of inflation upon the Company is difficult to measure. Inflation may
affect the borrowing needs of consumers, thereby impacting the growth rate of
the Company’s assets. Inflation may also affect the general level of interest
rates, which can have a direct bearing on the Company.





Management
believes that the most significant impact on financial results is the Company’s
ability to react to changes in interest rates. As discussed previously,
management is attempting to maintain a position that is within conservative
parameters for interest sensitive assets and liabilities in order to be
protected against wide interest rate fluctuations.





ITEM
7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





As
previously stated in this document, the Federal Reserve Bank decreased the Fed
Funds Rate a total of 425 basis points in 2008.  While short-term
rates decreased, longer rates have remained somewhat stationary.  This
has caused a steeper yield curve which can have an effect of increasing the
Bank’s earnings growth.  This is due to the payment of lower,
short-term deposit interest while at the same time experiencing little or no
deterioration to interest income from longer maturity loans.  With
this being said, the Bank monitors this interest sensitivity on a monthly
basis.  The results of the latest simulation follow. The simulation
shows a possible decrease in net interest income of 7.80%, or $1,356,000, in a
+200 basis point rate shock scenario over a one-year period.  A
decrease of 0.01% or $1,000 is shown in the model at a   -200
basis point rate shock.  The Bank will continue to monitor this rate
sensitivity going forward.  See previous discussions on Interest Rate
Sensitivity.





Equity
value at risk is monitored regularly and is within established policy
limits.





The
Company is not a party to any forward contract, interest rate swap, option
interest, or similar derivations instruments. The Company does not deal in
foreign currency.


44


ITEM
8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA








REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




To the
Board of Directors and Stockholders


Peoples
Financial Services Corp.


Hallstead,
Pennsylvania




We have
audited the accompanying consolidated balance sheets of Peoples Financial
Services Corp. and subsidiaries as of December 31, 2008 and 2007, and the
related consolidated statements of income, stockholders’ equity and cash flows
for each of the years in the three-year period ended December 31,
2008.  Peoples Financial Service Corp.’s management is responsible for
these consolidated financial statements.  Our responsibility is to
express an opinion on these consolidated financial statements based on our
audits.




We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audits to obtain reasonable assurance about whether
the consolidated financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the consolidated financial
statements.  An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation.  We believe
that our audits provide a reasonable basis for our opinion.




In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Peoples Financial Services
Corp. and subsidiaries as of December 31, 2008 and 2007, and the results of
their operations and their cash flows for each of the years in the three-year
period ended December 31, 2008 in conformity with accounting principles
generally accepted in the United States of America.




We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), Peoples Financial Services Corp.’s internal
control over financial reporting as of December 31, 2008, based on criteria
established in Internal
Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO), and our report dated
March 14, 2009 expressed an unqualified opinion.









/s/ Beard
Miller Company LLP














Beard
Miller Company LLP


Allentown,
Pennsylvania


March 14,
2009




45
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


Consolidated
Balance Sheets


December
      31,2008
                    
                    
                    2007(In
      Thousands, Except Share Data)ASSETSCash
      and due from banks
                    
                    $
                    6,174
                    
                    
                    $
                    8,051Interest
      bearing deposits in other banks
                    
                    
                    1,782
                    
                    
                    
                    555Federal
      funds sold
                    
                    
                    10,577
                    
                    
                    
                    0Cash
      and Cash Equivalents
                    
                    
                    18,533
                    
                    
                    
                    8,606Securities
      available for sale
                    
                    
                    110,247
                    
                    
                    
                    112,746Loans
      receivable, net of allowance for loan losses 2008 $3,002; and 2007
      $2,451
                    
                    
                    313,606
                    
                    
                    
                    288,601Premises
      and equipment, net
                    
                    
                    7,542
                    
                    
                    
                    5,872Accrued
      interest receivable
                    
                    
                    2,526
                    
                    
                    
                    2,237Intangible
      assets
                    
                    
                    818
                    
                    
                    
                    1,076Other
      real estate owned
                    
                    
                    5,171
                    
                    
                    
                    5,237Bank
      owned life insurance
                    
                    
                    7,911
                    
                    
                    
                    7,614Other
      assets
                    
                    
                    6,022
                    
                    
                    
                    2,445Total
      Assets
                    
                    $
                    472,376
                    
                    
                    $
                    434,434LIABILITIES
      AND STOCKHOLDERS’ EQUITYLIABILITIESDeposits:Non-interest
      bearing
                    
                    $
                    55,324
                    
                    
                    $
                    53,731Interest-bearing
                    
                    
                    315,944
                    
                    
                    
                    273,699Total
      Deposits
                    
                    
                    371,268
                    
                    
                    
                    327,430Short-term
      borrowings
                    
                    
                    18,432
                    
                    
                    
                    22,848Long-term
      borrowings
                    
                    
                    39,691
                    
                    
                    
                    38,534Accrued
      interest payable
                    
                    
                    1,649
                    
                    
                    
                    925Other
      liabilities
                    
                    
                    1,616
                    
                    
                    
                    1,892Total
      Liabilities
                    
                    
                    432,656
                    
                    
                    
                    391,629STOCKHOLDERS’
      EQUITYCommon
      stock, par value $2 per share; authorized 12,500,000 shares; issued
      3,341,251 shares; outstanding 3,131,181 shares and 3,138,493 shares
      December 31, 2008 and 2007, respectively
                    
                    
                    6,683
                    
                    
                    
                    6,683Surplus
                    
                    
                    3,100
                    
                    
                    
                    3,083Retained
      earnings
                    
                    
                    39,375
                    
                    
                    
                    38,824Accumulated
      other comprehensive loss
                    
                    
                    (4,755
                    )
                    
                    
                    (1,390
                    )Treasury
      stock, at cost, 210,070 and 202,758 shares at December 31, 2008 and 2007,
      respectively
                    
                    
                    (4,683
                    )
                    
                    
                    (4,395
                    )Total
      Stockholders’ Equity
                    
                    
                    39,720
                    
                    
                    
                    42,805Total
      Liabilities and Stockholders’ Equity
                    
                    $
                    472,376
                    
                    
                    $
                    434,434


See
notes to consolidated financial statements
 46
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES




Consolidated
Statements of Income


Years
      Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006(In
      Thousands, Except Per Share Data)INTEREST
      INCOMELoans
      receivable, including fees
                    
                    $
                    19,871
                    
                    
                    $
                    19,481
                    
                    
                    $
                    17,996Securities:Taxable
                    
                    
                    3,771
                    
                    
                    
                    3,351
                    
                    
                    
                    3,032Tax-exempt
                    
                    
                    1,731
                    
                    
                    
                    1,717
                    
                    
                    
                    1,484Other
                    
                    
                    106
                    
                    
                    
                    62
                    
                    
                    
                    186Total
      Interest Income
                    
                    
                    25,479
                    
                    
                    
                    24,611
                    
                    
                    
                    22,698INTEREST
      EXPENSEDeposits
                    
                    
                    7,026
                    
                    
                    
                    9,019
                    
                    
                    
                    8,748Short-term
      borrowings
                    
                    
                    390
                    
                    
                    
                    640
                    
                    
                    
                    524Long-term
      borrowings
                    
                    
                    1,738
                    
                    
                    
                    1,446
                    
                    
                    
                    1,525Total
      Interest Expense
                    
                    
                    9,154
                    
                    
                    
                    11,105
                    
                    
                    
                    10,797Net
      Interest Income
                    
                    
                    16,325
                    
                    
                    
                    13,506
                    
                    
                    
                    11,901PROVISION
      FOR LOAN LOSSES
                    
                    
                    713
                    
                    
                    
                    280
                    
                    
                    
                    302Net
      Interest Income after Provision for Loan Losses
                    
                    
                    15,612
                    
                    
                    
                    13,226
                    
                    
                    
                    11,599OTHER
      INCOME (LOSS)Customer
      service fees
                    
                    
                    2,006
                    
                    
                    
                    1,947
                    
                    
                    
                    1,770Investment
      division commission income
                    
                    
                    411
                    
                    
                    
                    340
                    
                    
                    
                    260Earnings
      on investment in life insurance
                    
                    
                    296
                    
                    
                    
                    297
                    
                    
                    
                    281Other
      income
                    
                    
                    606
                    
                    
                    
                    626
                    
                    
                    
                    437Realized
      gain on sale of interest in insurance agency
                    
                    
                    0
                    
                    
                    
                    220
                    
                    
                    
                    0Net
      realized  gains (losses) on sales of securities available for
      sale
                    
                    
                    128
                    
                    
                    
                    (122
                    )
                    
                    
                    42Other
      than temporary security impairments
                    
                    
                    (5,256
                    )
                    
                    
                    0
                    
                    
                    
                    0Total
      Other Income (Loss)
                    
                    
                    (1,809
                    )
                    
                    
                    3,308
                    
                    
                    
                    2,790OTHER
      EXPENSESSalaries
      and employee benefits
                    
                    
                    4,831
                    
                    
                    
                    4,767
                    
                    
                    
                    4,498Occupancy
                    
                    
                    733
                    
                    
                    
                    788
                    
                    
                    
                    674Equipment
                    
                    
                    493
                    
                    
                    
                    508
                    
                    
                    
                    484FDIC
      insurance and assessments
                    
                    
                    227
                    
                    
                    
                    151
                    
                    
                    
                    127Professional
      fees and outside services
                    
                    
                    520
                    
                    
                    
                    371
                    
                    
                    
                    337Computer
      service and supplies
                    
                    
                    970
                    
                    
                    
                    785
                    
                    
                    
                    774Taxes,
      other than payroll and income
                    
                    
                    400
                    
                    
                    
                    386
                    
                    
                    
                    370Impairment
      charge-other real estate owned
                    
                    
                    0
                    
                    
                    
                    575
                    
                    
                    
                    0Amortization
      expense – deposit acquisition premiums
                    
                    
                    258
                    
                    
                    
                    255
                    
                    
                    
                    299Stationary
      and printing supplies
                    
                    
                    360
                    
                    
                    
                    339
                    
                    
                    
                    247Other
                    
                    
                    1,885
                    
                    
                    
                    1,641
                    
                    
                    
                    1,678Total
      Other Expenses
                    
                    
                    10,677
                    
                    
                    
                    10,566
                    
                    
                    
                    9,488Income
      before Income Taxes
                    
                    
                    3,126
                    
                    
                    
                    5,968
                    
                    
                    
                    4,901FEDERAL
      INCOME TAXES
                    
                    
                    87
                    
                    
                    
                    1,097
                    
                    
                    
                    772Net
      Income
                    
                    $
                    3,039
                    
                    
                    $
                    4,871
                    
                    
                    $
                    4,129EARNINGS
      PER SHAREBasic
                    
                    $
                    0.97
                    
                    
                    $
                    1.55
                    
                    
                    $
                    1.31Diluted
                    
                    $
                    0.97
                    
                    
                    $
                    1.55
                    
                    
                    $
                    1.31


See
notes to consolidated financial statements
 47
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


Consolidated
Statements of Stockholders’ Equity


Years
Ended December 31, 2008, 2007 and 2006


Common
                  Stock
                
                
                Surplus
                
                
                Retained
                  Earnings
                
                
                Accumulated
                  Other
                  Comprehensive
                  Loss
                
                
                Treasury
                  Stock
                
                
                Total(In
      Thousands, Except Share Data)Balance
      - December 31, 2005
                
                $
                6,683
                
                
                $
                2,995
                
                
                $
                34,599
                
                
                $
                (961
                )
                
                $
                (3,700
                )
                
                $
                39,616Comprehensive
      income:Net income
                
                
                0
                
                
                
                0
                
                
                
                4,129
                
                
                
                0
                
                
                
                0
                
                
                
                4,129Net change in unrealized gains
      (losses) on securities
                  available for sale, net of
      reclassification adjustment and taxes
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                566
                
                
                
                0
                
                
                
                566Total Comprehensive
      Income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                4,695Stock
      option expense
                
                
                0
                
                
                
                3
                
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                3Cash dividends
      declared, ($0.76 per share)
                
                
                0
                
                
                
                0
                
                
                
                (2,392
                )
                
                
                0
                
                
                
                0
                
                
                
                (2,392
                )Shares issued from
      treasury related to stock purchase plans (4,783 shares)
                
                
                0
                
                
                
                48
                
                
                
                0
                
                
                
                0
                
                
                
                53
                
                
                
                101Purchase of treasury
      stock (26,579 shares)
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                (783
                )
                
                
                (783
                )Balance
      - December 31, 2006
                
                
                6,683
                
                
                
                3,046
                
                
                
                36,336
                
                
                
                (395
                )
                
                
                (4,430
                )
                
                
                41,240Comprehensive
      income:Net income
                
                
                0
                
                
                
                0
                
                
                
                4,871
                
                
                
                0
                
                
                
                0
                
                
                
                4,871Net change in unrealized gains
      (losses) on securities
                  available for sale, net of
      reclassification adjustment and taxes
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                (995
                )
                
                
                0
                
                
                
                (995
                )Total Comprehensive
      Income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                3,876Stock
      option expense
                
                
                0
                
                
                
                3
                
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                3Cash dividends declared,
      ($0.76 per share)
                
                
                0
                
                
                
                0
                
                
                
                (2,383
                )
                
                
                0
                
                
                
                0
                
                
                
                (2,383
                )Shares issued from
      treasury related to stock purchase plans (8,119 shares)
                
                
                0
                
                
                
                34
                
                
                
                0
                
                
                
                0
                
                
                
                129
                
                
                
                163Purchase of treasury
      stock (3,500 shares)
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                (94
                )
                
                
                (94
                )Balance
      - December 31, 2007
                
                
                6,683
                
                
                
                3,083
                
                
                
                38,824
                
                
                
                (1,390
                )
                
                
                (4,395
                )
                
                
                42,805Cumulative
      effect of adoption of new accounting principle on January 1, 2008 (Note
      1)
                
                
                0
                
                
                
                0
                
                
                
                (71
                )
                
                
                0
                
                
                
                0
                
                
                
                (71
                )Comprehensive
      loss:Net income
                
                
                0
                
                
                
                0
                
                
                
                3,039
                
                
                
                0
                
                
                
                0
                
                
                
                3,039Net change in unrealized gains
      (losses) on securities
                  available for sale, net of
      reclassification adjustment and taxes
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                (5,152
                )
                
                
                0
                
                
                
                (5,152
                )Re-classification
      adjustment for impairment charges on securities, net of
    taxes
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                1,787
                
                
                
                0
                
                
                
                1,787Total Comprehensive
      Loss
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (326
                )Stock
      option expense
                
                
                0
                
                
                
                1
                
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                1Cash dividends declared,
      ($0.76 per share)
                
                
                0
                
                
                
                0
                
                
                
                (2,417
                )
                
                
                0
                
                
                
                0
                
                
                
                (2,417
                )Shares issued from
      treasury related to stock purchase plans (12,688 shares)
                
                
                0
                
                
                
                16
                
                
                
                0
                
                
                
                0
                
                
                
                218
                
                
                
                234Purchase of treasury
      stock (20,000 shares)
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                (506
                )
                
                
                (506
                )Balance
      - December 31, 2008
                
                $
                6,683
                
                
                $
                3,100
                
                
                $
                39,375
                
                
                $
                (4,755
                )
                
                $
                (4,683
                )
                
                $
                39,720


See
notes to consolidated financial statements
 48
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES




CONSOLIDATED STATEMENTS OF CASH
FLOWS


Years
      Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006(In
      Thousands)CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      income
                  
                  $
                  3,039
                  
                  
                  $
                  4,871
                  
                  
                  $
                  4,129Adjustments
      to reconcile net income to net cash provided byoperating
      activities:Depreciation
      and amortization
                  
                  
                  871
                  
                  
                  
                  891
                  
                  
                  
                  900Provision
      for loan losses
                  
                  
                  713
                  
                  
                  
                  280
                  
                  
                  
                  302(Gain)
      loss on sales or retirements of equipment
                  
                  
                  (1
                  )
                  
                  
                  0
                  
                  
                  
                  9Gain
      on sale of other real estate owned
                  
                  
                  (15
                  )
                  
                  
                  0
                  
                  
                  
                  (59
                  )Impairment
      charge-other real estate owned
                  
                  
                  0
                  
                  
                  
                  575
                  
                  
                  
                  0Amortization
      of securities’ premiums and accretion of discounts, net
                  
                  
                  145
                  
                  
                  
                  380
                  
                  
                  
                  417Amortization
      of deferred loan costs
                  
                  
                  304
                  
                  
                  
                  254
                  
                  
                  
                  267Gain
      on sale of interest in insurance agency
                  
                  
                  0
                  
                  
                  
                  (220
                  )
                  
                  
                  0(Gain)
      loss on sales of securities available for sale, net
                  
                  
                  (128
                  )
                  
                  
                  122
                  
                  
                  
                  (42
                  )Other
      than temporary security impairment
                  
                  
                  5,256
                  
                  
                  
                  0
                  
                  
                  
                  0Stock
      option expense
                  
                  
                  1
                  
                  
                  
                  3
                  
                  
                  
                  3Deferred
      income taxes (benefit)
                  
                  
                  (1,737
                  )
                  
                  
                  (83
                  )
                  
                  
                  14Net
      earnings on investment in life insurance
                  
                  
                  (296
                  )
                  
                  
                  (297
                  )
                  
                  
                  (281
                  )Proceeds
      from the sale of loans originated for sale
                  
                  
                  6,556
                  
                  
                  
                  6,127
                  
                  
                  
                  3,037Net
      gain on sale of loans originated for sale
                  
                  
                  (88
                  )
                  
                  
                  (38
                  )
                  
                  
                  (27
                  )Loans
      originated for sale
                  
                  
                  (6,391
                  )
                  
                  
                  (6,166
                  )
                  
                  
                  (3,090
                  )(Increase)
      decrease in assets:Accrued
      interest receivable
                  
                  
                  (289
                  )
                  
                  
                  (382
                  )
                  
                  
                  (28
                  )Other
      assets
                  
                  
                  (108
                  )
                  
                  
                  275
                  
                  
                  
                  (157
                  )Increase
      (decrease)in liabilities:Accrued
      interest payable
                  
                  
                  724
                  
                  
                  
                  222
                  
                  
                  
                  81Other
      liabilities
                  
                  
                  (347
                  )
                  
                  
                  279
                  
                  
                  
                  227Net
      Cash Provided by Operating Activities
                  
                  
                  8,209
                  
                  
                  
                  7,093
                  
                  
                  
                  5,702CASH
      FLOWS FROM INVESTING ACTIVITIESProceeds
      from sale of interest in insurance agency
                  
                  
                  0
                  
                  
                  
                  551
                  
                  
                  
                  0Proceeds
      from sale of available for sale securities
                  
                  
                  57,997
                  
                  
                  
                  60,489
                  
                  
                  
                  60,977Proceeds
      from maturities of and principal repayments on available for sale
      securities
                  
                  
                  5,755
                  
                  
                  
                  16,220
                  
                  
                  
                  12,555Purchase
      of available for sale securities
                  
                  
                  (71,624
                  )
                  
                  
                  (81,163
                  )
                  
                  
                  (73,973
                  )Net
      increase in loans
                  
                  
                  (26,198
                  )
                  
                  
                  (19,993
                  )
                  
                  
                  (18,868
                  )Purchase
      of premises and equipment
                  
                  
                  (2,283
                  )
                  
                  
                  (325
                  )
                  
                  
                  (1,016
                  )Proceeds
      from sale or retirements of equipment
                  
                  
                  1
                  
                  
                  
                  0
                  
                  
                  
                  60Proceeds
      from sale of other real estate
                  
                  
                  180
                  
                  
                  
                  130
                  
                  
                  
                  183Net
      Cash Used in Investing Activities
                  
                  
                  (36,172
                  )
                  
                  
                  (24,091
                  )
                  
                  
                  (20,082
                  )CASH
      FLOWS FROM FINANCING ACTIVITIESIncrease
      in deposits
                  
                  
                  43,838
                  
                  
                  
                  3,255
                  
                  
                  
                  26,651Proceeds
      from long-term borrowings
                  
                  
                  5,000
                  
                  
                  
                  11,275
                  
                  
                  
                  3,100Repayment
      of long-term borrowings
                  
                  
                  (3,843
                  )
                  
                  
                  (9,266
                  )
                  
                  
                  (1,345
                  )Net
      increase (decrease) in short-term borrowings
                  
                  
                  (4,416
                  )
                  
                  
                  10,274
                  
                  
                  
                  (5,268
                  )Proceeds
      from sale of treasury stock
                  
                  
                  234
                  
                  
                  
                  163
                  
                  
                  
                  101Purchase
      of treasury stock
                  
                  
                  (506
                  )
                  
                  
                  (94
                  )
                  
                  
                  (783
                  )Cash
      dividends paid
                  
                  
                  (2,417
                  )
                  
                  
                  (2,383
                  )
                  
                  
                  (2,392
                  )Net
      Cash Provided by Financing Activities
                  
                  
                  37,890
                  
                  
                  
                  13,224
                  
                  
                  
                  20,064Increase
      (Decrease) in Cash and Cash Equivalents
                  
                  
                  9,927
                  
                  
                  
                  (3,774
                  )
                  
                  
                  5,684CASH
      AND CASH EQUIVALENTS - BEGINNING
                  
                  
                  8,606
                  
                  
                  
                  12,380
                  
                  
                  
                  6,696CASH
      AND CASH EQUIVALENTS - ENDING
                  
                  $
                  18,533
                  
                  
                  $
                  8,606
                  
                  
                  $
                  12,380


See
notes to consolidated financial statements
 49
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES





CONSOLIDATED
STATEMENTS OF CASH FLOWS (CONTINUED)


Years
      Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006(In
      Thousands)SUPPLEMENTARY
      CASH FLOWS INFORMATIONInterest
      paid
                  
                  $
                  8,430
                  
                  
                  $
                  10,833
                  
                  
                  $
                  10,716Income
      taxes paid
                  
                  $
                  2,130
                  
                  
                  $
                  805
                  
                  
                  $
                  605SUPPLEMENTARY
      DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIESForeclosed
      real estate acquired in settlement of loans
                  
                  $
                  99
                  
                  
                  $
                  318
                  
                  
                  $
                  5,068Securities
      acquired in settlement of loans
                  
                  $
                  0
                  
                  
                  $
                  0
                  
                  
                  $
                  1,065




See
notes to consolidated financial statements
 50
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Principles
of Consolidation




The
consolidated financial statements include the accounts of Peoples Financial
Services Corp. (the “Company”) and its wholly-owned subsidiaries, Peoples
National Bank (the “Bank”), Peoples Advisors, LLC and Peoples Financial Capital
Corporation. The Bank has two wholly owned subsidiaries, Peoples Financial
Leasing, LLC and Peoples Investment Holdings, LLC. Peoples Financial Capital
Corporation, Peoples Investment Holdings, LLC, and Peoples Financial Leasing,
LLC were all incorporated in April of 2007. All significant intercompany
accounts and transactions have been eliminated in consolidation.




Nature
of Operations




The
Company provides a variety of financial services, through the Bank, to
individuals, small businesses and municipalities through its eight Pennsylvania
offices located in Hallstead, Hop Bottom, Susquehanna, Montrose, Nicholson,
Meshoppen, Tunkhannock and Glenburn Township which are small communities in
a rural setting.  In October of 2008, the Company opened its eighth
Pennsylvania office in Glenburn Township. This office is the Company’s
first presence in Lackawanna County. In 2002, the Company started operating
in New York with an office located in Norwich.  The Company opened an
office in Conklin, New York, in March 2003 at which time the Norwich office was
closed and its deposits transferred to the Conklin office.  The
Company opened two new offices in 2005, Deposit, New York, April 2005, and the
Town of Chenango, New York, June 2005.  The Bank’s primary deposits
are checking accounts, savings accounts and certificates of
deposit.  Its primary lending products are single-family residential
loans and loans to small businesses.  As a national bank, the Bank is
subject to regulation of the Office of the Comptroller of the Currency and the
Federal Deposit Insurance Corporation.  The Company is subject to
regulation of the Federal Reserve Bank.  Peoples Advisors, LLC is a
member-managed liability company under the laws of the Commonwealth of
Pennsylvania for the purpose of providing investment advisory services to the
general public. Peoples Financial Leasing, LLC provides employee leasing
services to the Bank. Peoples Investment Holdings, LLC is incorporated in the
state of Delaware and maintains and manages the intangible investments of the
Bank and the collection and distribution of the income from such investments or
from tangible investments located outside of Delaware. Peoples Financial Capital
Corporation is also incorporated in the state of Delaware and maintains and
manages the intangible investments of the Company and the collection and
distribution of the income from such investments or from tangible investments
located outside of Delaware.




Estimates




The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period.  Actual results could differ from those
estimates.




51
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





Material
estimates that are particularly susceptible to significant change in the near
term relate to the determination of the allowance for loan losses, the valuation
of real estate acquired in connection with foreclosures or in satisfaction of
loans, the valuation of deferred tax assets, the potential impairment of
restricted stock, and determination of other-than-temporary impairment losses on
securities.




Significant
Group Concentrations of Credit Risk




Most of
the Company’s activities are with customers located primarily in northern
Lackawanna, Susquehanna and Wyoming Counties of Pennsylvania, and Broome County
of New York.  Note 2 discusses the types of securities in which the
Company invests.  The concentrations of credit by type of loan are set
forth in Note 3.  The Company does not have any significant
concentrations to any one industry or customer.  Although the Company
has a diversified loan portfolio, its debtors’ ability to honor their contracts
is influenced by the region’s economy.




Presentation
of Cash Flows




For
purposes of cash flows, cash and cash equivalents include cash on hand and
amounts due from banks, interest-bearing deposits in other banks and federal
funds sold.




Securities




Securities
classified as available-for-sale are those securities that the Company intends
to hold for an indefinite period of time, but not necessarily to
maturity.  Any decision to sell a security classified as
available-for-sale would be based on various factors, including significant
movements in interest rates, changes in the maturity mix of the Company’s assets
and liabilities, liquidity needs, regulatory capital considerations and other
similar factors.  Securities available-for-sale are carried at fair
value.  Unrealized gains or losses are reported as increases or
decreases in other comprehensive income, net of the related deferred tax
effect.  Realized gains or losses, determined on the basis of the cost
of the specific securities sold, are included in earnings.  Premiums
and discounts are recognized in interest income using the interest method over
the period to maturity.




Common
equity securities include restricted investments, primarily Federal Home Loan
Bank and Federal Reserve Bank stock which are carried at cost and investments in
bank stocks which are carried at fair value.  Federal law requires a
member institution of the Federal Home Loan Bank and the Federal Reserve Bank to
hold stock according to a predetermined formula.




Declines
in the fair value of available-for-sale securities below their cost that are
deemed to be other than temporary are reflected in earnings as realized
losses.  In estimating other-than-temporary impairment losses,
management considers (1) the length of time and the extent to which the fair
value has been less than cost, (2) the financial condition and near-term
prospects of the issuer, and (3) the intent and ability of the Company to retain
its investment in the issuer for a period of time sufficient to allow for any
anticipated recovery in fair value.




52
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





Loans
Receivable




Loans
receivable that management has the intent and ability to hold for the
foreseeable future or until maturity or payoff are stated at their outstanding
unpaid principal balances, net of an allowance for loan losses and any deferred
fees or costs.  Interest income is accrued on the unpaid principal
balance.  Loan origination fees, net of certain direct origination
costs, are deferred and recognized over the contractual life of the related loan
as an adjustment to the yield.




The
accrual of interest is generally discontinued when the contractual payment of
principal or interest has become 90 days past due or management has serious
doubts about further collectability of principal or interest, even though the
loan is currently performing.  A loan may remain on accrual status if
it is in the process of collection and is either guaranteed or well
secured.  When a loan is placed on non-accrual status, unpaid interest
credited to income in the current year is reversed and unpaid interest accrued
in prior years is charged against the allowance for loan
losses.  Interest received on non-accrual loans generally is either
applied against principal or reported as interest income, according to
management’s judgment as to the collectability of
principal.  Generally, loans are restored to accrual status when the
obligation is brought current, has performed in accordance with the contractual
terms for a reasonable period of time and the ultimate collectability of the
total contractual principal and interest is no longer in doubt.




Loans
Held for Sale




Loans
originated and intended for sale in the secondary market are carried at the
lower of aggregate cost or fair value, as determined by aggregate outstanding
commitments from investors or current investor yield
requirements.  Net unrealized losses are recognized through a
valuation allowance by charges to income.  The Company had mortgages
of $0 and $77,000 held for sale at December 31, 2008 and 2007,
respectively.




Allowance
for Loan Losses




The
allowance for loan losses is established through provisions for loan losses
charged against income.  Loans deemed to be uncollectible are charged
against the allowance for loan losses, and subsequent recoveries, if any, are
credited to the allowance.




The
allowance for loan losses is maintained at a level considered adequate to
provide for losses that can be reasonably anticipated.  Management’s
periodic evaluation of the adequacy of the allowance is based on the Bank’s past
loan loss experience, known or inherent risks in the portfolio, adverse
situations that may affect the borrower’s ability to repay, the estimated value
of any underlying collateral, composition of the loan portfolio, current
economic conditions and other relevant factors.  This evaluation is
inherently subjective as it requires estimates that are susceptible to
significant revision as more information becomes available.




53
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





The
allowance consists of specific, general and unallocated
components.  The specific component relates to loans that are
classified as either doubtful, substandard or special mention.  For
such loans that are also classified as impaired, an allowance is established
when the discounted cash flows (or collateral value or observable market price)
of the impaired loan is lower than the carrying value for that
loan.  The general component covers non-classified loans and is based
on historical loss experience adjusted for qualitative factors.  An
unallocated component is maintained to cover uncertainties that could affect
management’s estimate of probable losses.  The unallocated component
of the allowance reflects the margin of imprecision inherent in the underlying
assumptions used in the methodologies for estimating specific and general losses
in the portfolio.




A loan is
considered impaired when, based on current information and events, it is
probable that the Bank will be unable to collect the scheduled payments of
principal or interest when due according to the contractual terms of the loan
agreement.  Factors considered by management in determining impairment
include payment status, collateral value and the probability of collecting
scheduled principal and interest payments when due.  Loans that
experience insignificant payment delays and payment shortfalls generally are not
classified as impaired.  Management determines the significance of
payment delays and payment shortfalls on a case-by-case basis, taking into
consideration all of the circumstances surrounding the loan and the borrower,
including the length of the delay, the reasons for the delay, the borrower’s
prior payment record and the amount of the shortfall in relation to the
principal and interest owed.  Impairment is measured on a loan-by-loan
basis for commercial and construction loans by either the present value of
expected future cash flows discounted at the loan’s effective interest rate, the
loan’s obtainable market price or the fair value of the collateral if the loan
is collateral dependent.




Large
groups of smaller balance homogeneous loans are collectively evaluated for
impairment.  Accordingly, the Bank does not separately identify
individual consumer and residential loans for impairment disclosures, unless
such loans are the subject of a restructuring agreement.




Premises
and Equipment




Premises
and equipment are stated at cost less accumulated
depreciation.  Depreciation is computed using the straight-line and
various accelerated methods over the following estimated useful lives of the
related assets:





YearsBuildings
      and improvements
                              
                              
                              7 -
      40Furniture,
      fixtures and equipment
                              
                              
                              3 -
      10





Maintenance,
repairs and minor replacements are expensed when incurred.  Gains and
losses on routine dispositions are reflected in current operations.




54
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





Transfers
of Financial Assets





Transfers
of financial assets, which include loan participation sales, are accounted for
as sales, when control over the assets has been surrendered.  Control
over transferred assets is deemed to be surrendered when (1) the assets
have been isolated from the Company, (2) the transferee obtains the right (free
of conditions that constrain it from taking advantage of that right) to pledge
or exchange the transferred assets and (3) the Company does not maintain
effective control over the transferred assets through an agreement to repurchase
them before their maturity.




Intangible
Assets




The Bank
has core deposit acquisition premiums which are being amortized over an
estimated life of fifteen years using the straight-line method.  These
intangible assets were $818,000 and $1,076,000 net of accumulated amortization
of $3,069,000 and $2,811,000 at December 31, 2008 and 2007,
respectively.  Amortization expense was $258,000 for 2008, $255,000
for 2007 and $299,000 for 2006. Amortization expense is estimated to be $258,000
per year for the next three years and $44,000 in 2012 as the fifteen year
amortization period expires.  The fluctuation in the 2006 expense is
due to impairment on the Norwich Branch deposit acquisition recognized in the
fourth quarter of 2006 which totaled $38,000.




Other
Real Estate Owned




Other
real estate owned is comprised of property acquired through a foreclosure
proceeding or acceptance of a deed-in-lieu of foreclosure and loans classified
as in-substance foreclosure.  The Company includes such properties in
other assets.  A loan is classified as in-substance foreclosure when
the Company has taken possession of the collateral regardless of whether formal
foreclosure proceedings take place.  Foreclosed assets initially are
recorded at fair value, net of estimated selling costs, at the date of
foreclosure establishing a new cost basis.  Subsequent declines in the
recorded value of the property prior to its disposal and costs to maintain the
assets are included in other expense.  In addition, any gain or loss
realized upon disposal is included in other income or expense.




Bank
Owned Life Insurance




The
Company invests in bank owned life insurance (“BOLI”) as a source of funding for
employee benefit expenses.  BOLI involves the purchasing of life
insurance by the Bank on a chosen group of employees.  The Company is
the owner and beneficiary of the policies.  This life insurance
investment is carried at the cash surrender value of the underlying
policies.




55
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





Income
Taxes




Deferred
income taxes are provided on the liability method whereby deferred tax assets
are recognized for deductible temporary differences and deferred tax liabilities
are recognized for taxable temporary differences.  Temporary
differences are the differences between the reported amounts of assets and
liabilities and their tax basis.  Deferred tax assets are reduced by a
valuation allowance when, in the opinion of management, it is more likely than
not that some portion of the deferred tax assets will not be
realized.  Deferred tax assets and liabilities are adjusted for the
effects of changes in tax laws and rates on the date of
enactment.  Peoples Financial Services Corp. and its subsidiaries file
a consolidated federal income tax return.




Advertising




The
Company follows the policy of charging marketing and advertising costs to
expense as incurred.  Advertising expense for the years ended
December 31, 2008, 2007, and 2006 was $201,000, $154,000 and $167,000,
respectively.




Earnings
per Common Share




Basic
earnings per share represent income available to common stockholders divided by
the weighted-average number of common shares outstanding during the
period.  Diluted earnings per share reflect additional common shares
that would have been outstanding if dilutive potential common shares had been
issued, as well as any adjustment to income that would result from the assumed
issuance.  Potential common shares that may be issued by the Company
relate solely to outstanding stock options, and are determined using the
treasury stock method.




56
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





Earnings
per Common Share (Continued)




The
following table shows the amounts used in computing earnings per share for the
years ended December 31, 2008, 2007 and 2006:




Income
      Numerator
                          
                          
                          Common
      Shares Denominator
                          
                          
                          EPS(In
      Thousands, Except Per Share Data)2008:Basic EPS
                          
                          $
                          3,039
                          
                          
                          
                          3,128
                          
                          
                          $
                          .97Dilutive effect of potential
      common stock,
                            stock options
      (4,523 options)
                          
                          
                          0
                          
                          
                          
                          5
                          
                          
                          
                          .00Diluted EPS
                          
                          $
                          3,039
                          
                          
                          
                          3,133
                          
                          
                          $
                          .972007:Basic EPS
                          
                          $
                          4,871
                          
                          
                          
                          3,136
                          
                          
                          $
                          1.55Dilutive effect of potential
      common stock,
                            stock options
      (9,984 options)
                          
                          
                          0
                          
                          
                          
                          10
                          
                          
                          
                          .00Diluted EPS
                          
                          $
                          4,871
                          
                          
                          
                          3,146
                          
                          
                          $
                          1.552006:Basic EPS
                          
                          $
                          4,129
                          
                          
                          
                          3,144
                          
                          
                          $
                          1.31Dilutive
      effect of potential common stock,
                            stock options
      (12,074 options)
                          
                          
                          0
                          
                          
                          
                          12
                          
                          
                          
                          .00Diluted EPS
                          
                          $
                          4,129
                          
                          
                          
                          3,156
                          
                          
                          $
                          1.31





Stock
options for 10,900, 12,250, and 13,000 shares of common stock were anti-dilutive
and, accordingly, were not considered in computing diluted earnings per share
for the years ended December 31, 2008, 2007, and 2006,
respectively.





Comprehensive
Income




Accounting
principles generally accepted in the United States of America require that
recognized revenue, expenses, gains and losses be included in net
income.  Although certain changes in assets and liabilities, such as
unrealized gains and losses on available-for-sale securities, are reported as a
separate component of the equity section of the balance sheet, such items, along
with net income, are components of comprehensive income.




57
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





Comprehensive
Income (Continued)




The
components of other comprehensive income and related tax effects for the years
ended December 31, 2008, 2007 and 2006 are as follows:




2008
                    
                    
                    2007
                    
                    
                    2006(In
      Thousands)Unrealized
      holding gains (losses) on available for sale securities
                    
                    $
                    (10,226
                    )
                    
                    $
                    (1,629
                    )
                    
                    $
                    900Reclassification
      adjustment for (gains) losses realized in net income
                    
                    
                    (128
                    )
                    
                    
                    122
                    
                    
                    
                    (42
                    )Reclassification
      adjustment for other than temporary impairment charges
                    
                    
                    5,256
                    
                    
                    
                    0
                    
                    
                    
                    0Net
      Unrealized Gains (Losses)
                    
                    
                    (5,098
                    )
                    
                    
                    (1,507
                    )
                    
                    
                    858Tax
      effect
                    
                    
                    1,733
                    
                    
                    
                    512
                    
                    
                    
                    (292
                    )Net
      of Tax Amount
                    
                    $
                    (3,365
                    )
                    
                    $
                    (995
                    )
                    
                    $
                    566





Stock-Based
Compensation





Prior to
January 1, 2006, the Company’s stock option plan was accounted for under the
recognition and measurement provisions of APB Opinion No. 25 (Opinion 25), Accounting for Stock Issued to
Employees, and related Interpretations, as permitted by FASB Statement
No. 123, Accounting for Stock
Based Compensation (as amended by SFAS No. 148, Accounting for Stock-Based
Compensation Transition and Disclosure) (collectively SFAS 123). No
stock-based employee compensation cost was recognized in the Company’s
consolidated statements of income through December 31, 2005, as all options
granted under the plan had an exercise price equal to the market value of the
underlying common stock on the date of grant. Effective January 1, 2006, the
Company adopted the fair value recognition provisions of FASB Statement No.
123(R), Share-Based
Payment (SFAS 123(R)), using the modified-prospective transition method.
Under that transition method, compensation cost recognized in 2008, 2007 and
2006  includes: (a) compensation cost for all share-based payments
granted prior to, but not yet vested as of January 1, 2006 based on the grant
date fair value calculated in accordance with the original provisions of SFAS
123, and (b) compensation cost for all share-based payments granted subsequent
to December 31, 2005, based on a grant-date fair value estimated in accordance
with the provisions of SFAS 123(R).


58
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





Stock-Based
Compensation (Continued)





As of
December 31, 2007, the Company had 3,850 stock options not fully vested and
there was approximately $1,000 of total unrecognized compensation cost related
to these non-vested options. The cost was recognized monthly on a straight-line
basis through December 31, 2008.  For the year ended December 31, 2007
there were no stock options granted.  For the year ended December 31,
2007 there was stock option expense of $3,000 included in salaries and employee
benefits in the accompanying consolidated statement of income related to share
based payments granted prior to, but not yet vested as of January 1,
2006.  Therefore, as a result of adopting Statement No. 123(R) the
Company’s net income for the year ended December 31, 2007 was $3,000 lower than
if the Company had continued to account for share-based compensation under
Opinion No. 25.  Basic earnings per share and diluted earnings per
share for the year ended December 31, 2007 were not affected by the
adoption.





As of
December 31, 2008, all stock options were fully vested and there are no
unrecognized compensation costs related to stock options.  For the
year ended December 31, 2008 there were no stock options granted.  For
the year ended December 31, 2008 there was stock option expense of $1,000
included in salaries and employee benefits in the accompanying consolidated
statement of income related to share based payments granted prior to, but not
yet vested as of January 1, 2006.  Therefore, as a result of adopting
Statement No. 123(R) the Company’s net income for the year ended December 31,
2008 was $1,000 lower than if the Company had continued to account for
share-based compensation under Opinion No. 25.  Basic earnings per
share and diluted earnings per share for the year ended December 31, 2008 were
not affected by the adoption.





Segment
Reporting




The Bank
acts as an independent community financial services provider and offers
traditional banking and related financial services to individual, business and
government customers.  Through its branch and automated teller machine
network, the Bank offers a full array of commercial and retail financial
services, including:  the taking of time, savings and demand deposits;
the making of commercial, consumer and mortgage loans; and the providing of
other financial services.




Management
does not separately allocate expenses, including the cost of funding loan
demand, between the commercial and retail operations of the Bank.  As
such, discrete information is not available and segment reporting would not be
meaningful.




Peoples
Advisors, LLC provides investment advisory services to the general
public.  This company is included in the banking and financial
services segment of the Bank.




Peoples
Financial Leasing, LLC provides employee leasing services to the
Bank.




59
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





Segment
Reporting (Continued)





Peoples
Investment Holdings, LLC manages the intangible investments of the Bank and the
collection and distribution of the income from such investments or from tangible
investments located outside of Delaware.




Peoples
Financial Capital Corporation maintains and manages the intangible investments
of the Company and the collection and distribution of the income from such
investments or from tangible investments located outside of
Delaware.




Off-Balance
Sheet Financial Instruments




In the
ordinary course of business, the Company has entered into off-balance sheet
financial instruments consisting of commitments to extend credit and standby
letters of credit.  Such financial instruments are recorded in the
consolidated financial statements when they are funded.




New
Accounting Standards





In March
2008, the FASB issued Statement No. 161, “Disclosures about Derivative
Instruments and Hedging Activities—an amendment of FASB Statement No. 133”
(Statement 161).  Statement 161 requires entities that utilize
derivative instruments to provide qualitative disclosures about their objectives
and strategies for using such instruments, as well as any details of
credit-risk-related contingent features contained within
derivatives.  Statement 161 also requires entities to disclose
additional information about the amounts and location of derivatives located
within the financial statements, how the provisions of SFAS 133 has been
applied, and the impact that hedges have on an entity’s financial position,
financial performance, and cash flows.  Statement 161 is effective for
fiscal years and interim periods beginning after November 15, 2008, with early
application encouraged. The Company is currently evaluating the potential impact
the new pronouncement will have on its consolidated financial
statements.





In
February 2008, the FASB issued FASB Staff Position (FSP) FAS 140-3, “Accounting
for Transfers of Financial Assets and Repurchase Financing Transactions.” This
FSP addresses the issue of whether or not these transactions should be viewed as
two separate transactions or as one "linked" transaction. The FSP includes a
"rebuttable presumption" that presumes linkage of the two transactions unless
the presumption can be overcome by meeting certain criteria. The FSP will be
effective for fiscal years beginning after November 15, 2008 and will apply only
to original transfers made after that date; early adoption will not be allowed.
The Company is currently evaluating the potential impact the new pronouncement
will have on its consolidated financial statements.


60
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





New
Accounting Standards (Continued)





In
September 2006, the FASB reached consensus on the guidance provided by Emerging
Issues Task Force Issue 06-4 (EITF 06-4) "Accounting for Deferred Compensation
and Postretirement Benefit Aspects of Endorsement Split Dollar Life Insurance
Arrangements.”  The guidance is applicable to endorsement split-dollar
life insurance arrangements, whereby the employer owns and controls the
insurance policies that are associated with a postretirement benefit. EITF 06-4
requires that for a split-dollar life insurance arrangement within the scope of
the Issue, an employer should recognize a liability for future benefits in
accordance with FASB No. 106 (if, in substance, a postretirement benefit plan
exists) or, Accounting Principles Board Opinion No. 12 (if the arrangement is,
in substance, an individual deferred compensation contract) based on the
substantive agreement with the employee. The Company adopted this standard on
January 1, 2008 as a change in accounting principle through a cumulative-effect
adjustment to retained earnings totaling $71,000.





FASB
Statement No. 157 “Fair Value Measurements” defines fair value, establishes a
framework for measuring the fair value in generally accepted accounting
principles, and expands disclosures about fair value measurements (see Note 14 –
Fair Value of Financial Instruments).





FASB
Statement No. 159 “The Fair Value Option for Financial Assets and Financial
Liabilities – Including an Amendment of FASB Statement No. 115” permits entities
to choose to measure eligible items at fair value at specified election
dates.  The Company did not elect to apply this statement to any items in
the year ended December 31, 2008.





FASB
Statement No. 141 (R) “Business Combinations” was issued in December of 2007.
This Statement establishes principles and requirements for how the acquirer of a
business recognizes and measures in its financial statements the identifiable
assets acquired, the liabilities assumed, and any noncontrolling interest in the
acquiree. The Statement also provides guidance for recognizing and measuring the
goodwill acquired in the business combination and determines what information to
disclose to enable users of the financial statements to evaluate the nature and
financial effects of the business combination. The guidance will become
effective as of the beginning of a company’s fiscal year beginning after
December 15, 2008. This new pronouncement will impact the Company’s accounting
for business combinations completed beginning January 1, 2009.





FASB
Statement No. 160 “Noncontrolling Interests in Consolidated Financial
Statements—an amendment of ARB No. 51” was issued in December of 2007. This
Statement establishes accounting and reporting standards for the noncontrolling
interest in a subsidiary and for the deconsolidation of a subsidiary. The
guidance will become effective as of the beginning of a company’s fiscal year
beginning after December 15, 2008. The Company believes that this new
pronouncement will have an immaterial impact on the Company’s consolidated
financial statements in future periods.


61
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





New
Accounting Standards (Continued)





Staff
Accounting Bulletin No. 110 (SAB 110) amends and replaces Question 6 of
Section D.2 of Topic 14,“Share-Based Payment,” of the Staff Accounting Bulletin series. Question
6 of Section D.2 of Topic 14 expresses the views of the staff regarding the use
of the “simplified” method in developing an estimate of expected term of “plain
vanilla” share options and allows usage of the “simplified” method for share
option grants prior to December 31, 2007. SAB 110 allows public companies
which do not have historically sufficient experience to provide a reasonable
estimate to continue use of the “simplified” method for estimating the expected
term of “plain vanilla” share option grants after December 31,
2007.  The Company adopted SAB 110 on January 1, 2008 and it did
not have an effect on the consolidated financial statements.





Staff
Accounting Bulletin No. 109 (SAB 109), "Written Loan Commitments Recorded at
Fair Value Through Earnings" expresses the views of the staff regarding written
loan commitments that are accounted for at fair value through earnings under
generally accepted accounting principles. To make the staff's views consistent
with current authoritative accounting guidance, the SAB revises and rescinds
portions of SAB No. 105, "Application of Accounting Principles to Loan
Commitments."  Specifically, the SAB revises the SEC staff's views on
incorporating expected net future cash flows related to loan servicing
activities in the fair value measurement of a written loan commitment. The SAB
retains the staff's views on incorporating expected net future cash flows
related to internally-developed intangible assets in the fair value measurement
of a written loan commitment. The staff expects registrants to apply the views
in Question 1 of SAB 109 on a prospective basis to derivative loan commitments
issued or modified in fiscal quarters beginning after December 15, 2007. The
Company adopted SAB 109 on January 1, 2008 and it did not have an effect on
the consolidated financial statements.





In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles.”  This Statement identifies the sources of
accounting principles and the framework for selecting the principles used in the
preparation of financial statements.  This Statement is effective 60
days following the SEC’s approval of the Public Company Accounting Oversight
Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity
with Generally Accepted Accounting Principles.”  The Company is
currently evaluating the potential impact the new pronouncement will have on its
consolidated financial statements.





In April
2008, the FASB issued FASB Staff Position (“FSP”) FAS 142-3, “Determination of
the Useful Life of Intangible Assets.”  This FSP amends the factors
that should be considered in developing renewal or extension assumptions used to
determine the useful life of a recognized intangible asset under FASB Statement
No. 142, “Goodwill and Other Intangible Assets” (“SFAS
142”).  The intent of this FSP is to improve the consistency between
the useful life of a recognized intangible asset under SFAS 142 and the
period of expected cash flows used to measure the fair value of the asset under
SFAS 141(R), and other GAAP.  This FSP is effective for financial
statements issued for fiscal years beginning after December 15, 2008, and
interim periods within those fiscal years. Early adoption is
prohibited.  The Company is currently evaluating the potential impact
the new pronouncement will have on its consolidated financial
statements.


62
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





New
Accounting Standards (Continued)





In June
2008, the FASB issued FASB Staff Position (FSP) EITF 03-6-1, “Determining
Whether Instruments Granted in Share-Based Payment Transactions Are
Participating Securities.”  This FSP clarifies that all outstanding
unvested share-based payment awards that contain rights to non-forfeitable
dividends participate in undistributed earnings with common
shareholders.  Awards of this nature are considered participating
securities and the two-class method of computing basic and diluted earnings per
share must be applied.  This FSP is effective for fiscal years
beginning after December 15, 2008.  The Company is currently
evaluating the potential impact the new pronouncement will have on its
consolidated financial statements.





In June
2008, the FASB ratified EITF Issue No. 07-5, “Determining Whether an Instrument
(or an Embedded Feature) Is Indexed to an Entity’s Own Stock” (EITF
07-5).  EITF 07-5 provides that an entity should use a two step
approach to evaluate whether an equity-linked financial instrument (or embedded
feature) is indexed to its own stock, including evaluating the instrument’s
contingent exercise and settlement provisions.  It also clarifies the
impact of foreign currency denominated strike prices and market-based employee
stock option valuation instruments on the evaluation.  EITF 07-5 is
effective for fiscal years beginning after December 15, 2008.  The
Company is currently evaluating the potential impact the new pronouncement will
have on its consolidated financial statements.




In
September 2008, the FASB issued FSP 133-1 and FIN 45-4, “Disclosures about
Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No.
133 and FASB Interpretation No. 45; and Clarification of the Effective Date of
FASB Statement No. 161” (FSP 133-1 and FIN 45-4).  FSP 133-1 and FIN
45-4 amends and enhances disclosure requirements for sellers of credit
derivatives and financial guarantees.  It also clarifies that the
disclosure requirements of SFAS No. 161 are effective for quarterly periods
beginning after November 15, 2008, and fiscal years that include those
periods.  FSP 133-1 and FIN 45-4 is effective for reporting periods
(annual or interim) ending after November 15, 2008.  The
implementation of this standard did not have a material impact on our
consolidated financial position and results of operations.


63
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





New
Accounting Standards (Continued)





In
September 2008, the FASB ratified EITF Issue No. 08-5, “Issuer’s Accounting for
Liabilities Measured at Fair Value With a Third-Party Credit Enhancement” (EITF
08-5).  EITF 08-5 provides guidance for measuring liabilities issued
with an attached third-party credit enhancement (such as a
guarantee).  It clarifies that the issuer of a liability with a
third-party credit enhancement should not include the effect of the credit
enhancement in the fair value measurement of the liability.  EITF 08-5
is effective for the first reporting period beginning after December 15,
2008.  The Company is currently assessing the impact of EITF 08-5 on
its consolidated financial position and results of operations.





In
December 2008, the FASB issued FSP SFAS 140-4 and FASB Interpretation (FIN)
46(R)-8, “Disclosures by Public Entities (Enterprises) about Transfers of
Financial Assets and Interests in Variable Interest Entities” (FSP SFAS 140-4
and FIN 46(R)-8). FSP SFAS 140-4 and FIN 46(R)-8 amends FASB SFAS 140
“Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities”, to require public entities to provide additional disclosures
about transfers of financial assets. It also amends FIN 46(R), “Consolidation of
Variable Interest Entities”, to require public enterprises, including sponsors
that have a variable interest in a variable interest entity, to provide
additional disclosures about their involvement with variable interest entities.
Additionally, this FSP requires certain disclosures to be provided by a public
enterprise that is (a) a sponsor of a qualifying special purpose entity (SPE)
that holds a variable interest in the qualifying SPE but was not the transferor
of financial assets to the qualifying SPE and (b) a servicer of a qualifying SPE
that holds a significant variable interest in the qualifying SPE but was not the
transferor of financial assets to the qualifying SPE. The disclosures required
by FSP SFAS 140-4 and FIN 46(R)-8 are intended to provide greater transparency
to financial statement users about a transferor’s continuing involvement with
transferred financial assets and an enterprise’s involvement with variable
interest entities and qualifying SPEs. FSP SFAS 140-4 and FIN 46(R) is effective
for reporting periods (annual or interim) ending after December 15, 2008. The
implementation of these standards did not have a material impact on our
consolidated financial position and results of operations.





In
January 2009, the FASB issued FSP EITF 99-20-1, “Amendments to the Impairment of
Guidance of EITF Issue No. 99-20” (FSP EITF 99-20-1). FSP EITF 99-20-1 amends
the impairment guidance in EITF Issue No. 99-20, “Recognition of Interest Income
and Impairment on Purchased Beneficial Interests and Beneficial Interests That
Continue to Be Held by a Transferor in Securitized Financial Assets”, to achieve
more consistent determination of whether an other-than-temporary impairment has
occurred. FSP EITF 99-20-1 also retains and emphasizes the objective of an
other-than-temporary impairment assessment and the related disclosure
requirements in SFAS No. 115, “Accounting for Certain Investments in Debt and
Equity Securities”, and other related guidance. FSP EITF 99-20-1 is effective
for interim and annual reporting periods ending after December 15, 2008, and
shall be applied prospectively. Retrospective application to a prior interim or
annual reporting period is not permitted. The implementation of these standards
did not have a material impact on our consolidated financial position and
results of operations.


64
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





New
Accounting Standards (Continued)





In
November 2008, the SEC released a proposed roadmap regarding the potential use
by U.S. issuers of financial statements prepared in accordance with
International Financial Reporting Standards (IFRS). IFRS is a comprehensive
series of accounting standards published by the International Accounting
Standards Board (“IASB”). Under the proposed roadmap, the Company may be
required to prepare financial statements in accordance with IFRS as early as
2014. The SEC will make a determination in 2011 regarding the mandatory adoption
of IFRS. The Company is currently assessing the impact that this potential
change would have on its consolidated financial statements, and it will continue
to monitor the development of the potential implementation of IFRS.




In
November 2008, the FASB ratified Emerging Issues Task Force (EITF) Issue
No. 08-6, “Equity Method Investment Accounting Considerations”.
EITF 08-6 clarifies the accounting for certain transactions and impairment
considerations involving equity method investments. EITF 08-6 is effective
for fiscal years beginning after December 15, 2008, with early adoption
prohibited. The Company is currently reviewing the effect this new pronouncement
will have on its consolidated financial statements.





In
November 2008, the FASB ratified Emerging Issues Task Force Issue No. 08-7,
“Accounting for Defensive Intangible Assets”. EITF 08-7 clarifies the
accounting for certain separately identifiable intangible assets which an
acquirer does not intend to actively use but intends to hold to prevent its
competitors from obtaining access to them. EITF 08-7 requires an acquirer
in a business combination to account for a defensive intangible asset as a
separate unit of accounting which should be amortized to expense over the period
the asset diminishes in value. EITF 08-7 is effective for fiscal years
beginning after December 15, 2008, with early adoption
prohibited.  This new pronouncement will impact the Company’s
accounting for any defensive intangible assets acquired in a business
combination completed beginning January 1, 2009.





Reclassifications





Certain
amounts in the 2007 and 2006 financial statements have been reclassified to
conform to 2008 presentation.  Those reclassifications had no effect
on net income.


65
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
2 – SECURITIES




At
December 31, 2008 and 2007, the amortized cost and fair values of
securities available-for-sale are as follows:





Amortized
                  Cost
                
                
                Gross
                  Unrealized
                  Gains
                
                
                Gross
                  Unrealized
                  Losses
                
                
                Fair
                  Value(In
      Thousands)December
      31, 2008:U.S. Government agencies andcorporations
                
                $
                7,891
                
                
                $
                67
                
                
                $
                0
                
                
                $
                7,958Obligations of state and
      politicalsubdivisions
                
                
                47,914
                
                
                
                120
                
                
                
                (3,319
                )
                
                
                44,715Taxable
      obligations of state and political subdivisions
                
                
                3,166
                
                
                
                0
                
                
                
                (106
                )
                
                
                3,060Corporate debt
      securities
                
                
                20,828
                
                
                
                40
                
                
                
                (3,898
                )
                
                
                16,970Mortgage-backed
      securities
                
                
                32,487
                
                
                
                325
                
                
                
                (47
                )
                
                
                32,765Preferred equity
      securities
                
                
                78
                
                
                
                0
                
                
                
                (58
                )
                
                
                20Common equity
      securities
                
                
                5,086
                
                
                
                25
                
                
                
                (352
                )
                
                
                4,759Total
                
                $
                117,450
                
                
                $
                577
                
                
                $
                (7,780
                )
                
                $
                110,247December
      31, 2007:U.S. Government agencies andcorporations
                
                $
                1,999
                
                
                $
                3
                
                
                $
                0
                
                
                $
                2,002Obligations of state and
      politicalsubdivisions
                
                
                45,357
                
                
                
                28
                
                
                
                (880
                )
                
                
                44,505Taxable
      obligations of state and political subdivisions
                
                
                1,995
                
                
                
                0
                
                
                
                (1
                )
                
                
                1,994Corporate debt
      securities
                
                
                11,493
                
                
                
                35
                
                
                
                (263
                )
                
                
                11,265Mortgage-backed
      securities
                
                
                45,256
                
                
                
                241
                
                
                
                (329
                )
                
                
                45,168Preferred equity
      securities
                
                
                2,367
                
                
                
                0
                
                
                
                (526
                )
                
                
                1,841Common equity
      securities
                
                
                6,384
                
                
                
                29
                
                
                
                (442
                )
                
                
                5,971Total
                
                $
                114,851
                
                
                $
                336
                
                
                $
                (2,441
                )
                
                $
                112,746


66
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
2 – SECURITIES (CONTINUED)





The
amortized cost and fair value of securities as of December 31, 2008, by
contractual maturity, are shown below.  Expected maturities may differ
from contractual maturities because borrowers may have the right to prepay
obligations with or without any penalties.





Amortized
                            Cost
                        
                        
                        Fair
                            Value(In
      Thousands)Due
      in one year or less
                        
                        $
                        1,329
                        
                        
                        $
                        1,302Due
      after one year through five years
                        
                        
                        12,177
                        
                        
                        
                        11,536Due
      after five years through ten years
                        
                        
                        34,930
                        
                        
                        
                        31,222Due
      after ten years
                        
                        
                        31,363
                        
                        
                        
                        28,64379,799
                        
                        
                        
                        72,703Mortgage-backed
      securities
                        
                        
                        32,487
                        
                        
                        
                        32,765Equity
      securities
                        
                        
                        5,164
                        
                        
                        
                        4,779$
                        117,450
                        
                        
                        $
                        110,247





Proceeds
from sale of available-for-sale securities during 2008, 2007 and 2006 were
$57,997,000, $60,489,000, and $60,977,000, respectively.  Gross gains
realized on these sales were $412,000, $186,000, and $663,000,
respectively.  Gross losses on these sales were $284,000, $308,000,
and $621,000, respectively.




Securities
with a carrying value of $43,313,000 and $33,189,000 at December 31, 2008
and 2007, respectively, were pledged to secure public deposits and repurchase
agreements as required or permitted by law.




67
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
2 – SECURITIES (CONTINUED)





The
following tables show the Company’s investments’ gross unrealized losses and
fair value, aggregated by investment category and length of time that individual
securities have been in a continuous unrealized loss position at
December 31, 2008 and 2007 (in thousands):




December
31, 2008:




Less
      Than 12 Months
                        
                        
                        12
      Months or More
                        
                        
                        TotalFair
      Value
                        
                        Unrealized
      Losses
                        
                        
                        Fair
      Value
                        
                        Unrealized
      Losses
                        
                        
                        Fair
      Value
                        
                        Unrealized
      LossesObligations
      of state and political subdivisions
                        
                        $
                        34,301
                        
                        $
                        (2,376
                        )
                        
                        $
                        2,570
                        
                        $
                        (943
                        )
                        
                        $
                        36,871
                        
                        $
                        (3,319
                        )Taxable
      obligations of state and political subdivisions
                        
                        
                        3,060
                        
                        
                        (106
                        )
                        
                        
                        0
                        
                        
                        0
                        
                        
                        
                        3,060
                        
                        
                        (106
                        )Corporate
      debt securities
                        
                        
                        8,752
                        
                        
                        (2,878
                        )
                        
                        
                        7,420
                        
                        
                        (1,020
                        )
                        
                        
                        16,172
                        
                        
                        (3,898
                        )Mortgage-backed
      securities
                        
                        
                        11,242
                        
                        
                        (41
                        )
                        
                        
                        1,305
                        
                        
                        (6
                        )
                        
                        
                        12,547
                        
                        
                        (47
                        )Preferred
      equity securities
                        
                        
                        20
                        
                        
                        (58
                        )
                        
                        
                        0
                        
                        
                        0
                        
                        
                        
                        20
                        
                        
                        (58
                        )Common
      equity securities
                        
                        
                        166
                        
                        
                        (37
                        )
                        
                        
                        687
                        
                        
                        (315
                        )
                        
                        
                        853
                        
                        
                        (352
                        )Total
      Temporarily Impaired Securities
                        
                        $
                        57,541
                        
                        $
                        (5,496
                        )
                        
                        $
                        11,982
                        
                        $
                        (2,284
                        )
                        
                        $
                        69,680
                        
                        $
                        (7,780
                        )





December
31, 2007:





Less
      Than 12 Months
                        
                        
                        12
      Months or More
                        
                        
                        TotalFair
      Value
                        
                        Unrealized
      Losses
                        
                        
                        Fair
      Value
                        
                        Unrealized
      Losses
                        
                        
                        Fair
      Value
                        
                        Unrealized
      LossesObligations
      of state and political subdivisions
                        
                        $
                        27,688
                        
                        $
                        (746
                        )
                        
                        $
                        12,447
                        
                        $
                        (134
                        )
                        
                        $
                        40,135
                        
                        $
                        (880
                        )Taxable
      obligations of state and political subdivisions
                        
                        
                        491
                        
                        
                        (1
                        )
                        
                        
                        0
                        
                        
                        0
                        
                        
                        
                        491
                        
                        
                        (1
                        )Corporate
      debt securities
                        
                        
                        6,942
                        
                        
                        (126
                        )
                        
                        
                        2,207
                        
                        
                        (137
                        )
                        
                        
                        9,149
                        
                        
                        (263
                        )Mortgage-backed
      securities
                        
                        
                        4,099
                        
                        
                        (23
                        )
                        
                        
                        20,438
                        
                        
                        (306
                        )
                        
                        
                        24,537
                        
                        
                        (329
                        )Preferred
      equity securities
                        
                        
                        1,841
                        
                        
                        (526
                        )
                        
                        
                        0
                        
                        
                        0
                        
                        
                        
                        1,841
                        
                        
                        (526
                        )Common
      equity securities
                        
                        
                        1,383
                        
                        
                        (442
                        )
                        
                        
                        0
                        
                        
                        0
                        
                        
                        
                        1,383
                        
                        
                        (442
                        )Total
      Temporarily Impaired Securities
                        
                        $
                        42,444
                        
                        $
                        (1,864
                        )
                        
                        $
                        35,092
                        
                        $
                        (577
                        )
                        
                        $
                        77,536
                        
                        $
                        (2,441
                        )




68
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
2 - SECURITIES (CONTINUED)





At
December 31, 2008, the Company had 74 obligations of state and political
subdivisions with unrealized losses of $3,425,000, 10 mortgage-backed securities
with unrealized losses of $47,000, 13 corporate debt securities with unrealized
losses of $3,898,000, 2 preferred equity securities with unrealized losses of
$58,000, and 14 common equity securities, primarily bank stocks, in an
unrealized loss position of $327,000. These common equity securities have
traditionally been high-performing stocks.  As a result of recent
market volatility in financial stocks from news of the economic downturn, the
fair value of most of the stocks held are “under water” as of December 31, 2008,
and as such, are considered to be impaired.  The Company does not
invest in bank stocks with the intent to turn them over for a profit in the
near-term.  We invest in those stocks that we believe to have
potential to appreciate in value over the long-term, while providing for a
reasonable dividend yield.  We buy and hold those stocks that we
believe have potential to be an acquirer or to be acquired, providing additional
value.  Stocks can be cyclical in nature and will experience some down
periods.  Historically, bank stocks have sustained cyclical losses,
followed by periods of substantial gains, therefore we believe that both
unrealized losses and gains are likely to be temporary, when observing
performance in the banking sector. In management’s opinion, the unrealized
losses on all other securities reflect changes in interest rates subsequent to
the acquisition of specific securities.  The Company has the intent
and the ability to hold such securities until maturity or market price
recovery.  Management believes that the unrealized losses represent
temporary impairment of the securities.





The
Company recorded other than temporary impairments of $5,256,000 for the year
ended December 31, 2008. These impairments were the result of writing down two
separate bond issuances of Lehman Brother Holdings for $2,580,000, two preferred
equity securities of the Federal Home Loan Mortgage Corp. (FHLMC) for
$2,289,000, and five common equity securities for $387,000. These write-downs
were measured based on public market prices. In reaching the determination to
record these impairments, management reviewed the facts and circumstances
available surrounding the securities, including the duration and amount of the
unrealized loss, the financial condition of the issuer and the prospects for a
change in market value within a reasonable period of time. Based on its
assessment, management determined that the impairment was other-than-temporary
and that a charge was appropriate for these securities.





Management
evaluates securities for other-than-temporary impairment at least on a quarterly
basis, and more frequently when economic or market concerns warrant such
evaluation.  Consideration is given to (1) the length of time and the
extent to which the fair value has been less than cost, (2) the financial
condition and near-term prospects of the issuer, and (3) the intent and ability
of the Company to retain its investment in the issuer for a period of time
sufficient to allow for any anticipated recovery in fair value.





Restricted
stock which represents a required investment in the common stock of a
correspondent bank is carried at cost as of December 31, 2008 and
2007.  In December 2008, the FHLB of Pittsburgh notified member banks
that it was suspending dividend payments and the repurchase of capital
stock.  The Company had $2,559,000 of FHLB stock as of December 31,
2008.


69
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
2 - SECURITIES (CONTINUED)





Management
evaluates the restricted stock for impairment in accordance with Statement of
Position (SOP) 01-6, Accounting by Certain Entities (Including Entities With
Trade Receivables) That Lend to or Finance the Activities of
Others.  Management’s determination of whether these investments are
impaired is based on their assessment of the ultimate recoverability of their
cost rather than by recognizing temporary declines in value.  The
determination of whether a decline affects the ultimate recoverability of their
cost is influenced by criteria such as (1) the significance of the decline in
net assets of the FHLB as compared to the capital stock amount for the FHLB and
the length of time this situation has persisted, (2) commitments by the FHLB to
make payments required by law or regulation and the level of such payments in
relation to the operating performance of the FHLB, and (3) the impact of
legislative and regulatory changes on institutions and, accordingly, on the
customer base of the FHLB.





Management
believes no impairment charge is necessary related to the FHLB stock as of
December 31, 2008.




70
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
3 - LOANS RECEIVABLE





The
composition of loans receivable at December 31, 2008 and 2007 is as
follows:




December
      31,2008
                              
                              
                              2007(In
      Thousands)Commercial
                              
                              $
                              71,258
                              
                              
                              $
                              63,091Real
      estate:Commercial
                              
                              
                              107,084
                              
                              
                              
                              92,705Residential
                              
                              
                              120,813
                              
                              
                              
                              116,922Consumer
                              
                              
                              16,988
                              
                              
                              
                              17,889316,143
                              
                              
                              
                              290,607Unearned
      net loan origination fees and costs
                              
                              
                              465
                              
                              
                              
                              445Allowance
      for loan losses
                              
                              
                              (3,002
                              )
                              
                              
                              (2,451
                              )$
                              313,606
                              
                              
                              $
                              288,601





A summary
of the transactions in the allowance for loan losses is as follows:




Years
      Ended December 31,2008
                                        
                                        
                                        2007
                                        
                                        
                                        2006(In
      Thousands)Balance,
      beginning
                                        
                                        $
                                        2,451
                                        
                                        
                                        $
                                        1,792
                                        
                                        
                                        $
                                        2,375Provision for loan
      losses
                                        
                                        
                                        713
                                        
                                        
                                        
                                        280
                                        
                                        
                                        
                                        302Recoveries
                                        
                                        
                                        84
                                        
                                        
                                        
                                        452
                                        
                                        
                                        
                                        31Loans charged off
                                        
                                        
                                        (246
                                        )
                                        
                                        
                                        (73
                                        )
                                        
                                        
                                        (916
                                        )Balance,
      ending
                                        
                                        $
                                        3,002
                                        
                                        
                                        $
                                        2,451
                                        
                                        
                                        $
                                        1,792





The total
recorded investment in impaired loans was $5,116,000 and $395,000 at
December 31, 2008 and 2007, respectively.  The required allowance
for loan losses on these loans was $624,000 and $0 at December 31, 2008 and
2007, respectively.  At December 31, 2008, impaired loans of
$2,792,000 required a specific reserve of $624,000.  At December 31,
2008, impaired loans of $2,324,000 did not require a specific
reserve.  For the years ended December 31, 2008, 2007 and 2006,
the average balance of these impaired loans was $2,695,000, $496,000, and
$449,000, respectively.  The Company recognizes income on impaired
loans under the cash basis when the collateral on the loan is sufficient to
cover the outstanding obligation to the Company.  If these factors do
not exist, the Company will record all payments as a reduction of principal on
such loans.


71
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
3 - LOANS RECEIVABLE (CONTINUED)





The
recorded investment of impaired loans at December 31, 2008 and 2007 included
loans on which the accrual of interest has been discontinued of $602,000 and
$395,000 respectively.  If interest on non-accrual loans had been
accrued throughout the period, interest income for the years ended December 31,
2008, 2007 and 2006, would have increased approximately $26,000, $32,000 and
$84,000 respectively.  The amount of interest income on these loans
that was included in net income for the years ended December 31, 2008, 2007 and
2006 was $27,000, $15,000 and $7,000, respectively.  The recorded
investment in loans past due 90 or more days and accruing interest at December
31, 2008 and 2007 was $245,000 and $91,000, respectively.




Loans
outstanding to directors, executive officers, principal stockholders or to their
affiliates totaled $2,665,000 and $2,740,000 at December 31, 2008 and 2007,
respectively.  Advances and repayments during 2008 totaled $1,338,000
and $1,413,000, respectively.  These loans are made during the
ordinary course of business at the Company’s normal credit
terms.  There were no related party loans that were classified as
non-accrual, past due, or restructured or were considered a potential credit
risk at December 31, 2008 and 2007.





The
Company has signed a participating member agreement to sell residential
mortgages to Fannie Mae. The balance of loans sold as of December 31, 2008 to
Fannie Mae is $8,051,000.  The Company continues to service loans that
were sold to the FHLB of Pittsburgh (“FHLB”).  The agreement, with
FHLB, included a maximum credit enhancement of $178,000 which the Company may be
required to pay if realized losses on any of the sold mortgages exceed the
amount held in the FHLB’s Spread Account.  The FHLB is funding the
Spread Account at 0.25% of the outstanding balance of loans sold. The balance of
loans sold as of December 31, 2008 to FHLB is $9,812,000.  The
Company’s historical losses on residential mortgages have been lower than the
amount being funded to the Spread Account.  As such, the Company does
not anticipate recognizing any losses and accordingly, has not recorded a
liability for the credit enhancement.  As compensation for the credit
enhancement, the FHLB is paying the Company 0.10% of the outstanding loan
balance in the portfolio on a monthly basis.





The
Company retains the servicing on the loans sold to Fannie Mae and FHLB and
receives a fee based upon the principal balance outstanding.  During
the years ended 2008 and 2007, the Company recognized $60,000 and $64,000,
respectively, of servicing assets and amortized $24,000 and $13,000,
respectively. The balance outstanding was $119,000 and $83,000 at December 31,
2008 and 2007, respectively.  The fair value of the servicing assets
was $119,000 and $83,000 at December 31, 2008 and 2007, respectively, and was
based on market quotes for pools of the mortgages stratified by rate and
maturity date.


72
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
4 - PREMISES AND EQUIPMENT





Premises
and equipment at December 31, 2008 and 2007 are comprised of the
following:




2008
                                
                                
                                2007(In
      Thousands)Land
                                
                                $
                                805
                                
                                
                                $
                                398Building
      and improvements
                                
                                
                                7,567
                                
                                
                                
                                6,500Furniture,
      fixtures and equipment
                                
                                
                                6,595
                                
                                
                                
                                5,80514,967
                                
                                
                                
                                12,703Accumulated
      depreciation
                                
                                
                                (7,425
                                )
                                
                                
                                (6,831
                                )$
                                7,542
                                
                                
                                $
                                5,872





Depreciation
expense was $613,000, $636,000, and $601,000 for the years ended
December 31, 2008, 2007 and 2006, respectively.




NOTE
5 – DEPOSITS





The
composition of deposits at December 31, 2008 and 2007 were as
follows:





2008
                          
                          
                          2007(In
      Thousands)Demand:Non-interest
    bearing
                          
                          $
                          55,324
                          
                          
                          $
                          53,731Interest bearing
                          
                          
                          64,533
                          
                          
                          
                          64,150Savings
                          
                          
                          87,106
                          
                          
                          
                          100,103Time:$100,000 and over
                          
                          
                          47,622
                          
                          
                          
                          25,930Less than
$100,000
                          
                          
                          116,683
                          
                          
                          
                          83,516$
                          371,268
                          
                          
                          $
                          327,430




At
December 31, 2008, the scheduled maturities of time deposits are as follows
(in thousands):




2009
                  
                  $
                  130,1132010
                  
                  
                  8,7562011
                  
                  
                  5,8492012
                  
                  
                  10,3552013
                  
                  
                  5,892Thereafter
                  
                  
                  3,340$
                  164,305





73
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
6 - SHORT-TERM BORROWINGS





Securities
sold under agreements to repurchase and Federal Home Loan Bank advances
generally represent overnight or less than 30-day borrowings.  U.S.
Treasury tax and loan notes for collections made by the Bank are payable on
demand.  Short-term borrowings consisted of the following at
December 31, 2008, 2007 and 2006:







At
      and for the year ended December 31, 2008Ending
                              Balance
                            
                            
                            Average
                              Balance
                            
                            
                            Maximum
                              Month-End
                              Balance
                            
                            
                            Average
                              Rate(Dollars
      In Thousands)Securities
      sold under agreements to repurchase
                            
                            $
                            17,351
                            
                            
                            $
                            12,775
                            
                            
                            $
                            17,351
                            
                            
                            
                            2.10
                            %Federal
      Home Loan Bank
                            
                            
                            0
                            
                            
                            
                            3,575
                            
                            
                            
                            9,950
                            
                            
                            
                            3.16
                            %U.S.
      Treasury tax and loan notes
                            
                            
                            1,081
                            
                            
                            
                            524
                            
                            
                            
                            1,081
                            
                            
                            
                            1.45
                            %$
                            18,432
                            
                            
                            $
                            16,874
                            
                            
                            $
                            28,382
                            
                            
                            
                            2.30
                            %










At
      and for the year ended December 31, 2007Ending
                            Balance
                          
                          
                          Average
                            Balance
                          
                          
                          Maximum
                            Month-End
                            Balance
                          
                          
                          Average
      Rate(Dollars
      In Thousands)Securities
      sold under agreements to repurchase
                          
                          $
                          10,281
                          
                          
                          $
                          10,269
                          
                          
                          $
                          11,722
                          
                          
                          
                          3.01
                          %Federal
      Home Loan Bank
                          
                          
                          11,965
                          
                          
                          
                          6,029
                          
                          
                          
                          12,716
                          
                          
                          
                          5.07
                          %U.S.
      Treasury tax and loan notes
                          
                          
                          602
                          
                          
                          
                          503
                          
                          
                          
                          1,014
                          
                          
                          
                          4.39
                          %$
                          22,848
                          
                          
                          $
                          16,801
                          
                          
                          $
                          25,452
                          
                          
                          
                          3.79
                          %







At
      and for the year ended December 31, 2006Ending
                            Balance
                          
                          
                          Average
                            Balance
                          
                          
                          Maximum
                            Month-End
                            Balance
                          
                          
                          Average
      Rate(Dollars
      In Thousands)Securities
      sold under agreements to repurchase
                          
                          $
                          11,591
                          
                          
                          $
                          10,946
                          
                          
                          $
                          13,394
                          
                          
                          
                          4.07
                          %Federal
      Home Loan Bank
                          
                          
                          0
                          
                          
                          
                          1,239
                          
                          
                          
                          6,510
                          
                          
                          
                          4.83
                          %U.S.
      Treasury tax and loan notes
                          
                          
                          983
                          
                          
                          
                          418
                          
                          
                          
                          1,019
                          
                          
                          
                          4.46
                          %$
                          12,574
                          
                          
                          $
                          12,603
                          
                          
                          $
                          20,923
                          
                          
                          
                          4.16
                          %


74
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
6 - SHORT-TERM BORROWINGS (CONTINUED)





The Bank
has an agreement with the Federal Home Loan Bank (FHLB) which allows for
borrowings up to a percentage of qualifying assets.  At
December 31, 2008, the Bank had a maximum borrowing capacity for short-term
and long-term advances of approximately $163,245,000, of which $39,691,000 was
outstanding in short and long-term borrowings.  All advances from FHLB
are secured by qualifying assets of the Bank.




Securities
sold under repurchase agreements are retained under the Bank’s control at its
safekeeping agent.  The Bank may be required to provide additional
collateral based on the fair value of the underlying securities.  The
weighted average interest rate on securities sold under repurchase agreements at
December 31, 2008 was 2.09%.




Securities
owned by the Company provide collateral for U.S. Treasury tax and loan
notes.




The Bank
has a $7,000,000 line of credit for the sale of federal funds with Atlantic
Central Bankers Bank of which $0 was outstanding at December 31, 2008 and
2007.  These borrowings are unsecured.




NOTE
7 - LONG-TERM BORROWINGS




Long-term
debt consisted of advances from the Federal Home Loan Bank under various
notes.




Due
                              
                              Convertible
                              
                              
                              Strike
                                Rate
                              
                              
                              Current
                                Interest
                                Rate
                              
                              
                              2008
                              
                              
                              2007(Dollars
      In Thousands)September
      2011
                              
                              
                              N/A
                              
                              
                              
                              N/A
                              
                              
                              
                              5.05
                              %
                              
                              $
                              523
                              
                              
                              $
                              696February
      2016
                              
                              
                              N/A
                              
                              
                              
                              N/A
                              
                              
                              
                              4.86
                              %
                              
                              
                              840
                              
                              
                              
                              936February
      2016
                              
                              
                              N/A
                              
                              
                              
                              N/A
                              
                              
                              
                              4.86
                              %
                              
                              
                              841
                              
                              
                              
                              936October
      2011
                              
                              January
      2009
                              
                              
                              
                              8.00
                              %
                              
                              
                              4.47
                              %
                              
                              
                              2,500
                              
                              
                              
                              2,500September
      2012
                              
                              March
      2009
                              
                              
                              
                              8.00
                              %
                              
                              
                              3.69
                              %
                              
                              
                              5,000
                              
                              
                              
                              5,000February
      2009
                              
                              
                              N/A
                              
                              
                              
                              N/A
                              
                              
                              
                              4.80
                              %
                              
                              
                              70
                              
                              
                              
                              477February
      2013
                              
                              February
      2009
                              
                              
                              
                              8.00
                              %
                              
                              
                              3.59
                              %
                              
                              
                              5,000
                              
                              
                              
                              5,000February
      2008
                              
                              
                              N/A
                              
                              
                              
                              N/A
                              
                              
                              
                              2.69
                              %
                              
                              
                              0
                              
                              
                              
                              107June
      2014
                              
                              March
      2009
                              
                              
                              
                              8.00
                              %
                              
                              
                              4.47
                              %
                              
                              
                              5,000
                              
                              
                              
                              5,000January
      2015
                              
                              January
      2009
                              
                              
                              
                              8.00
                              %
                              
                              
                              4.31
                              %
                              
                              
                              5,000
                              
                              
                              
                              5,000November
      2015
                              
                              
                              N/A
                              
                              
                              
                              N/A
                              
                              
                              
                              4.67
                              %
                              
                              
                              1,627
                              
                              
                              
                              1,822February
      2017
                              
                              
                              N/A
                              
                              
                              
                              N/A
                              
                              
                              
                              4.99
                              %
                              
                              
                              2,790
                              
                              
                              
                              3,060August
      2008
                              
                              
                              N/A
                              
                              
                              
                              N/A
                              
                              
                              
                              4.86
                              %
                              
                              
                              0
                              
                              
                              
                              2,500August
      2010
                              
                              
                              N/A
                              
                              
                              
                              N/A
                              
                              
                              
                              4.85
                              %
                              
                              
                              2,500
                              
                              
                              
                              2,500December
      2011
                              
                              
                              N/A
                              
                              
                              
                              N/A
                              
                              
                              
                              4.12
                              %
                              
                              
                              3,000
                              
                              
                              
                              3,000January
      2013
                              
                              February
      2010
                              
                              
                              
                              N/A
                              
                              
                              
                              2.67
                              %
                              
                              
                              5,000
                              
                              
                              
                              0$
                              39,691
                              
                              
                              $
                              38,534




75
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
7 - LONG-TERM BORROWINGS (CONTINUED)





Detail of long-term debt
at December 31, 2008 and 2007 is as follows:





On
convertible rate notes, the Federal Home Loan Bank has the option to convert the
notes at rates ranging from the three-month LIBOR (1.81% at December 31,
2008) plus .15% to plus .28% on a quarterly basis, if greater than the
applicable strike rate, commencing on the conversion date.  If
converted, the Bank has the option to repay these advances at each of the option
dates without penalty.




Maturities
of long-term debt, by contractual maturity, in years subsequent to
December 31, 2008 are as follows (in thousands):





2009
                                      
                                      $
                                      9412010
                                      
                                      
                                      3,4142011
                                      
                                      
                                      6,4092012
                                      
                                      
                                      5,7972013
                                      
                                      
                                      10,836Thereafter
                                      
                                      
                                      12,294$
                                      39,691





The notes
are secured under terms of a blanket collateral agreement by a pledge of
qualifying investment and mortgage-backed securities, certain mortgage loans and
a lien on FHLB stock.




76
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
8 - STOCK PURCHASE PLANS





The
Company has a stock option plan covering non-employee directors and a stock
incentive plan for all officers and key employees.  The Plan is
administered by a committee of the Board of Directors.  Under the
Plan, 187,500 shares of common stock are reserved for possible
issuance.  The number of shares available is subject to future
adjustment in the event of specified changes in the Company’s capital
structure.  Under the Plan, the exercise price cannot be less than
100% of the fair market value on the date of grant.  The vesting
period of options granted is at the discretion of the Board of
Directors.  There are 65,751 shares available for grant under this
stock option plan as of December 31, 2008.




A summary
of transactions under this Plan were as follows:




2008
                          
                          
                          2007
                          
                          
                          2006Options
                          
                          
                          Weighted
                            Average
                            Price
                          
                          
                          Options
                          
                          
                          Weighted
                            Average
                            Price
                          
                          
                          Options
                          
                          
                          Weighted
                            Average
                            PriceOutstanding,
      beginning of year
                          
                          
                          47,593
                          
                          
                          $
                          20.75
                          
                          
                          
                          56,467
                          
                          
                          $
                          20.03
                          
                          
                          
                          61,500
                          
                          
                          $
                          19.80Granted
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          0Exercised
                          
                          
                          (12,694
                          )
                          
                          
                          15.84
                          
                          
                          
                          (8,119
                          )
                          
                          
                          16.54
                          
                          
                          
                          (4,783
                          )
                          
                          
                          16.40Forfeited
                          
                          
                          (1,350
                          )
                          
                          
                          30.78
                          
                          
                          
                          (750
                          )
                          
                          
                          30.78
                          
                          
                          
                          (250
                          )
                          
                          
                          34.10Outstanding,
      end of year
                          
                          
                          33,549
                          
                          
                          $
                          21.78
                          
                          
                          
                          47,593
                          
                          
                          $
                          20.75
                          
                          
                          
                          56,467
                          
                          
                          $
                          20.03Exercisable,
      end of year
                          
                          
                          33,549
                          
                          
                          $
                          21.78
                          
                          
                          
                          43,743
                          
                          
                          $
                          20.15
                          
                          
                          
                          52,367
                          
                          
                          $
                          19.44





The
weighted-average remaining contractual life of the options outstanding is
approximately 4 years at December 31, 2008.  The weighted-average
remaining contractual life of options exercisable at December 31, 2008 is
approximately 4 years.  Stock options outstanding at December 31,
2008 are exercisable at prices ranging from $16.50 to $34.10 a
share.  At December 31, 2008 the aggregate intrinsic value of options
outstanding was $0 and the aggregate intrinsic value of options exercisable was
$0.  At December 31, 2007, the aggregate intrinsic value of options
outstanding was $335,000 and the aggregate intrinsic value of options
exercisable was $335,000.  At December 31, 2006, the aggregate
intrinsic value of options outstanding was $401,000 and the aggregate intrinsic
value of options exercisable was $401,000.  The aggregate intrinsic value
of options exercised was $33,000, $29,000, and $22,000 for the years ended
December 31, 2008, 2007, and 2006.




77
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
8 - STOCK PURCHASE PLANS (CONTINUED)





During
1999, the Company implemented a Dividend Reinvestment and Stock Purchase
Plan.  Under the Plan, the Company registered with the Securities and
Exchange Commission 100,000 shares of the common stock to be sold pursuant to
the Plan.  Participation is available to all common
stockholders.  The Plan provides each participant with a simple and
convenient method of purchasing additional common shares without payment of any
brokerage commission or other service fees.  The Plan may purchase
shares on the open market if available or they may be issued from treasury
shares.  A participant in the Plan may elect to reinvest dividends on
all or part of their shares to acquire additional common stock.  A
participant may withdraw from the Plan at any time.  Effective in
2005, the Plan was amended to permit stockholders participating in the Plan to
purchase additional shares of common stock with voluntary cash payments of a
minimum of $100 and a maximum of $850 each calendar month.  As of
December 31, 2008, there are 65,751 remaining shares available for issuance
under the Dividend Reinvestment and Stock Purchase Plan.





NOTE
9 - INCOME TAXES





In July
2006, the Financial Accounting Standards Board (FASB) issued Interpretation No.
48, Accounting for Uncertainty
in Income Taxes (FIN 48).   FIN 48 clarifies the
accounting for uncertainty in income taxes recognized in an enterprise’s
financial statements in accordance with FASB Statement 109, Accounting for Income
Taxes.  FIN 48 is effective for fiscal years beginning after
December 15, 2006.  The Company adopted FIN 48 as of January 1,
2007.  The Company has evaluated its tax positions as of January 1,
2007, December 31, 2007 and December 31, 2008, respectively.  A tax
position is recognized as a benefit only if it is “more likely than not” that
the tax position would be sustained in a tax examination, with a tax examination
being presumed to occur.  The amount recognized is the largest amount
of tax benefit that has a likelihood of being realized on examination of more
than 50 percent.  For tax positions not meeting the “more likely than
not” test, no tax benefit is recorded.  Under the
“more-likely-than-not” threshold guidelines, the Company believes no significant
uncertain tax positions exist, either individually or in the aggregate, that
would give rise to the non-recognition of an existing tax benefit.  As
of January 1, 2007, December 31, 2007 and December 31, 2008, respectively, the
Company had no material unrecognized tax benefits or accrued interest and
penalties.  The Company’s policy is to account for interest as a
component of interest expense and penalties as a component of other
expense.  The Company and its subsidiaries are subject to U.S. federal
income tax as well as income tax of the Commonwealth of Pennsylvania and State
of New York.  The Company is no longer subject to examination by U.S.
Federal taxing authorities for years before 2004 and for all state income taxes
through 2004.




The
provision for federal income taxes consists of the following:




Years
      Ended December 31,2008
                          
                          
                          2007
                          
                          
                          2006(In
      Thousands)Current
                          
                          $
                          1,824
                          
                          
                          $
                          1,180
                          
                          
                          $
                          758Deferred
                          
                          
                          (1,737
                          )
                          
                          
                          (83
                          )
                          
                          
                          14$
                          87
                          
                          
                          $
                          1,097
                          
                          
                          $
                          772




78
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
9 - INCOME TAXES (CONTINUED)





The
components of the net deferred tax asset at December 31, 2008 and 2007 are
as follows:




2008
                            
                            
                            2007(In
      Thousands)Deferred
      tax asset:Allowance
      for loan losses
                            
                            $
                            734
                            
                            
                            $
                            678Deferred
      loan fees
                            
                            
                            3
                            
                            
                            
                            4Deferred
      compensation
                            
                            
                            364
                            
                            
                            
                            374Other
                            
                            
                            32
                            
                            
                            
                            32Impairment
      on securities
                            
                            
                            1,871
                            
                            
                            
                            216Capital
      loss carry forward
                            
                            
                            152
                            
                            
                            
                            3Stock
      option expense
                            
                            
                            2
                            
                            
                            
                            2Alternative
      minimum tax credit
                            
                            
                            0
                            
                            
                            
                            27Impairment
      charge—other real estate owned
                            
                            
                            195
                            
                            
                            
                            196Unrealized
      loss on available for sale securities
                            
                            
                            2,449
                            
                            
                            
                            7155,802
                            
                            
                            
                            2,247Deferred
      tax liabilities:Depreciation
                            
                            
                            (251
                            )
                            
                            
                            (221
                            )Interest
      on preferred equity securities
                            
                            
                            (17
                            )
                            
                            
                            0Section
      481 Adjustment-Prepaid Expenses
                            
                            
                            (112
                            )
                            
                            
                            (85
                            )Section
      481 Adjustment-Deferred Loan Costs
                            
                            
                            (250
                            )
                            
                            
                            (239
                            )(630
                            )
                            
                            
                            (545
                            )Net
      Deferred Tax Asset
                            
                            $
                            5,172
                            
                            
                            $
                            1,702




In
assessing the realizability of deferred tax assets, management considers whether
it is more likely than not that some or all of the deferred tax assets will not
be realized. The ultimate realization of deferred tax assets is dependent upon
the generation of future taxable income during periods in which those temporary
differences become deductible. Management considers the scheduled reversal of
deferred tax liabilities, projected future taxable income and tax planning
strategies in making this assessment. Furthermore, as a result of the Emergency
Economic Stabilization Act of 2008 (ESSA) the resulting deferred tax asset
created by the other-than-temporary impairment of the Company’s preferred equity
holdings in the FHLMC does not require a valuation allowance to be recognized.
The loss is determined to be ordinary for tax purposes under the ESSA and any
future gains realized from selling those FHLMC holdings would also be treated as
ordinary for income tax purposes. The deferred tax asset for capital loss
carryforward above will be realized through future tax planning strategies of
the Company. Based on the level of historical taxable income and projections for
future taxable income and tax planning strategies over the periods in which the
deferred tax assets are deductible, management believes it is more likely than
not that the Company will realize the benefits of these deferred tax assets as
of December 31, 2008.





79
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
9 - INCOME TAXES (CONTINUED)





A
reconciliation of the provision for income taxes and the amount that would have
been provided at statutory rates for the years ended December 31 is as
follows:





2008
                          
                          
                          2007
                          
                          
                          2006Amount
                          
                          
                          %
      of
                            Pretax
                            Income
                          
                          
                          Amount
                          
                          
                          %
      of
                            Pretax
                            Income
                          
                          
                          Amount
                          
                          
                          %
      of
                            Pretax
                            Income(Dollars
      in Thousands)Federal
      income tax at statutory rate
                          
                          $
                          1,063
                          
                          
                          
                          34
                          %
                          
                          $
                          2,029
                          
                          
                          
                          34
                          %
                          
                          $
                          1,666
                          
                          
                          
                          34
                          %Tax
      exempt interest
                          
                          
                          (938
                          )
                          
                          
                          (30
                          )
                          
                          
                          (907
                          )
                          
                          
                          (15
                          )
                          
                          
                          (866
                          )
                          
                          
                          (18
                          )Non-deductible
      interest
                          
                          
                          96
                          
                          
                          
                          3
                          
                          
                          
                          116
                          
                          
                          
                          2
                          
                          
                          
                          119
                          
                          
                          
                          2Officers’
      life insurance income
                          
                          
                          (101
                          )
                          
                          
                          (3
                          )
                          
                          
                          (111
                          )
                          
                          
                          (2
                          )
                          
                          
                          (112
                          )
                          
                          
                          (2
                          )Other,
      net
                          
                          
                          (33
                          )
                          
                          
                          (1
                          )
                          
                          
                          (30
                          )
                          
                          
                          (1
                          )
                          
                          
                          (35
                          )
                          
                          
                          (0
                          )$
                          87
                          
                          
                          
                          3
                          %
                          
                          $
                          1,097
                          
                          
                          
                          18
                          %
                          
                          $
                          772
                          
                          
                          
                          16
                          %





The
income tax provision includes $44,000, $(41,000), and $14,000 in 2008, 2007
and 2006, respectively, of income tax (benefit) expense on net realized
securities gains and losses.




NOTE
10 - EMPLOYEE BENEFIT PLANS





The
Company has an employee stock ownership and profit-sharing plan with 401(k)
provisions.  The Plan is for the benefit of all employees who meet the
eligibility requirements set forth in the Plan. The amount of employer
contributions to the plan, including 401(k) matching contributions, is at the
discretion of the Board of Directors.  Employer ESOP contributions are
allocated to participant accounts based on their percentage of total
compensation for the Plan year.  During 2008, 2007 and 2006, ESOP
contributions to the Plan charged to operations were $151,000, $167,000, and
$131,000, respectively.  During 2008, 2007 and 2006, employer 401(k)
matching contributions to the Plan charged to operations were $94,000, $80,000,
and $79,000, respectively.  At December 31, 2008, 147,974 shares
of the Company’s common stock were held in the Plan.  In the event a
terminated Plan participant desires to sell his or her shares of the Company’s
stock, or for certain employees who elect to diversify their account balances,
the Company may be required to purchase the shares from the participant at their
fair market value.




The Bank
has deferred compensation agreements with its chief operating officer and
certain directors that provide fixed retirement benefits.  The Bank’s
deferred compensation liability as of December 31, 2008 and 2007 was
$1,071,000 and $1,099,000, respectively.  The cost charged to
operations for these deferred compensation plans was $58,000, $59,000, and
$177,000 for the years ended December 31, 2008, 2007 and 2006,
respectively.




NOTE
11 – CONTINGENCIES





The
Company is subject to lawsuits and claims arising out of its
business.  In the opinion of the Company’s management, after review
and consultation with counsel, any proceedings that may arise should not result
in judgments, which, in the aggregate, would have a material adverse effect on
the Company’s consolidated financial statements.


80
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
12 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK





The
Company is a party to financial instruments with off-balance sheet risk in the
normal course of business to meet the financing needs of its
customers.  These financial instruments include commitments to extend
credit and letters of credit.  Those instruments involve, to varying
degrees, elements of credit risk in excess of the amount recognized in the
consolidated balance sheets.




The
Company’s exposure to credit loss in the event of nonperformance by the other
party to the financial instrument for commitments to extend credit and letters
of credit is represented by the contractual amount of those
instruments.  The Company uses the same credit policies in making
commitments and conditional obligations as it does for on-balance sheet
instruments.




The
contract or notional amounts at December 31, 2008 and 2007 were as
follows:




2008
                              
                              
                              2007(In
      Thousands)Commitments
      to grant loans
                              
                              $
                              8,892
                              
                              
                              $
                              6,904Unfunded
      commitments under lines of credit
                              
                              
                              30,687
                              
                              
                              
                              28,618Standby
      letters of credit
                              
                              
                              5,259
                              
                              
                              
                              4,550$
                              44,838
                              
                              
                              $
                              40,072





Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract.  Since many of
the commitments are expected to expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash
requirements.  Commitments generally have fixed expiration dates or
other termination clauses and may require payment of a fee.  The
Company evaluates each customer’s credit worthiness on a case-by-case
basis.  The amount of collateral obtained, if deemed necessary by the
Company upon extension of credit, is based on management’s credit
evaluation.  Collateral held varies but may include personal or
commercial real estate, accounts receivable, inventory and
equipment.





Outstanding
letters of credit written are conditional commitments issued by the Company to
guarantee the performance of a customer to a third party.




The
majority of these standby letters of credit expire within the next twelve
months.  The credit risk involved in issuing letters of credit is
essentially the same as that involved in extending other loan
commitments.  The Company requires collateral supporting these letters
of credit as deemed necessary.  The maximum undiscounted exposure
related to these commitments at December 31, 2008 and 2007 was $5,259,000
and $4,550,000, respectively and the approximate value of underlying collateral
upon liquidation that would be expected to cover this maximum potential exposure
was $4,168,000 and $3,363,000, respectively.  The current amount of
the liability as of December 31, 2008 and 2007 for guarantees under standby
letters of credit issued is not material.




81
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
13 - REGULATORY MATTERS





The Bank
is required to maintain average cash reserve balances in vault cash and with the
Federal Reserve Bank based on a percentage of deposits.  The required
reserve balance at December 31, 2008 and 2007 was $576,000 and $851,000,
respectively.




Dividends
are paid by the Company from its assets, which are mainly provided by dividends
from the Bank.  However, certain restrictions exist regarding the
ability of the Bank to transfer funds to the Company in the form of cash
dividends, loans or advances.  Under such restrictions, the Bank may
not, without the prior approval of the Comptroller of the Currency, declare
dividends in excess of the sum of the current year’s earnings (as defined) plus
the retained earnings (as defined) from the prior two years.




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




Quantitative
measures established by regulation to ensure capital adequacy require the
maintenance of minimum amounts and ratios (set forth in the table below) of
total and Tier 1 capital (as defined in the regulations) to risk-weighted assets
(as defined) and of Tier 1 capital to average assets (as
defined).  Management believes, as of December 31, 2008, that the
Company and Bank meet all capital adequacy requirements to which they are
subject.





As of
December 31, 2008, the most recent notification from the Office of the
Comptroller of the Currency categorized the Bank as “well capitalized” under the
regulatory framework for prompt corrective action.  To be categorized
as “well capitalized”, the Bank must maintain minimum total risk-based, Tier 1
risk-based and Tier 1 leverage ratios as set forth in the table
below.  There are no conditions or events since that notification that
management believes have changed the Bank’s category.




82
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
13 - REGULATORY MATTERS (CONTINUED)





The
Company and Bank’s actual capital ratios as of December 31, 2008 and 2007,
and the minimum ratios required for capital adequacy purposes and to be well
capitalized under the prompt corrective action provisions are as
follows:




Actual
                            
                            
                            For
      Capital Adequacy Purposes
                            
                            
                            To
      be Well Capitalized under Prompt Corrective Action
    ProvisionsAmount
                            
                            
                            Ratio
                            
                            
                            Amount
                            
                            
                            Ratio
                            
                            
                            Amount
                            
                            
                            Ratio(Dollars
      in Thousands)As
      of December 31, 2008:Total capital (to risk-weighted
      assets):Consolidated
                            
                            $
                            46,659
                            
                            
                            
                            13.10
                            %
                            
                            $
                            328,490
                            
                            
                            
                            38.00
                            %
                            
                            
                            N/A
                            
                            
                            
                            N/APeoples National
    Bank
                            
                            
                            42,402
                            
                            
                            
                            12.00
                            
                            
                            
                            328,261
                            
                            
                            
                            38.00
                            
                            
                            $
                            335,326
                            
                            
                            
                            310.00
                            %Tier 1 capital (to risk-weighted
      assets):Consolidated
                            
                            
                            43,657
                            
                            
                            
                            12.26
                            
                            
                            
                            314,245
                            
                            
                            
                            34.00
                            
                            
                            
                            N/A
                            
                            
                            
                            N/APeoples National
    Bank
                            
                            
                            39,400
                            
                            
                            
                            11.15
                            
                            
                            
                            314,130
                            
                            
                            
                            34.00
                            
                            
                            
                            321,196
                            
                            
                            
                            36.00Tier 1 capital (to average
      assets):Consolidated
                            
                            
                            43,657
                            
                            
                            
                            9.31
                            
                            
                            
                            318,765
                            
                            
                            
                            34.00
                            
                            
                            
                            N/A
                            
                            
                            
                            N/APeoples National
    Bank
                            
                            
                            39,400
                            
                            
                            
                            8.45
                            
                            
                            
                            318,648
                            
                            
                            
                            34.00
                            
                            
                            
                            323,310
                            
                            
                            
                            35.00As
      of December 31, 2007:Total capital (to risk-weighted
      assets):Consolidated
                            
                            $
                            45,570
                            
                            
                            
                            14.42
                            %
                            
                            $
                            325,283
                            
                            
                            
                            38.00
                            %
                            
                            
                            N/A
                            
                            
                            
                            N/APeoples National
    Bank
                            
                            
                            40,741
                            
                            
                            
                            13.02
                            
                            
                            
                            325,025
                            
                            
                            
                            38.00
                            
                            
                            $
                            331,281
                            
                            
                            
                            310.00
                            %Tier 1 capital (to risk-weighted
      assets):Consolidated
                            
                            
                            43,119
                            
                            
                            
                            13.64
                            
                            
                            
                            312,642
                            
                            
                            
                            34.00
                            
                            
                            
                            N/A
                            
                            
                            
                            N/APeoples National
    Bank
                            
                            
                            38,290
                            
                            
                            
                            12.24
                            
                            
                            
                            312,512
                            
                            
                            
                            34.00
                            
                            
                            
                            318,769
                            
                            
                            
                            36.00Tier 1 capital (to average
      assets):Consolidated
                            
                            
                            43,119
                            
                            
                            
                            10.14
                            
                            
                            
                            317,002
                            
                            
                            
                            34.00
                            
                            
                            
                            N/A
                            
                            
                            
                            N/APeoples National
    Bank
                            
                            
                            38,290
                            
                            
                            
                            9.09
                            
                            
                            
                            316,852
                            
                            
                            
                            34.00
                            
                            
                            
                            321,065
                            
                            
                            
                            35.00




83
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
14 - FAIR VALUE OF FINANCIAL INSTRUMENTS





Management
uses its best judgment in estimating the fair value of the Company’s financial
instruments; however, there are inherent weaknesses in any estimation
technique.  Therefore, for substantially all financial instruments,
the fair value estimates herein are not necessarily indicative of the amounts
the Company could have realized in a sales transaction on the dates
indicated.  The estimated fair value amounts have been measured as of
their respective year-ends and have not been re-evaluated or updated for
purposes of these financial statements subsequent to those respective
dates.  As such, the estimated fair values of these financial
instruments subsequent to the respective reporting dates may be different than
the amounts reported at each year-end.




In
September 2006, the Financial Accounting Standards Board (“FASB”) issued
Statement No. 157, Fair
Value Measurements (“SFAS 157”), which defines fair value, establishes a
framework for measuring fair value under GAAP, and expands disclosures about
fair value measurements.  SFAS 157 applies to other accounting
pronouncements that require or permit fair value measurements.  The
Company adopted SFAS 157 effective for its fiscal year beginning January 1,
2008.




In
December 2007, the FASB issued FASB Staff Position 157-2, Effective Date of FASB Statement No.
157 (“FSP 157-2”).  FSP 157-2 delays the effective date of SFAS
157 for all non-financial assets and liabilities, except those that are
recognized or disclosed at fair value on a recurring basis (at least annually)
to fiscal years beginning after November 15, 2008 and interim periods
within those fiscal years.  As such, the Company only partially
adopted the provisions of SFAS 157, and will begin to account and report for
non-financial assets and liabilities in 2009.  In October 2008, the
FASB issued FASB Staff Position 157-3,Determining the Fair Value of a
Financial Asset When the Market for that Asset is Not Active
(“FSP 157-3”), to clarify the application of the provisions of
SFAS 157 in an inactive market and how an entity would determine fair value
in an inactive market.  FSP 157-3 is effective immediately and
applies to the Company’s December 31, 2008 consolidated financial
statements.  The adoption of SFAS 157 and FSP 157-3 had no
impact on the amounts reported in the consolidated financial statements.




SFAS 157
establishes a fair value hierarchy that prioritizes the inputs to valuation
methods used to measure fair value.  The hierarchy gives the highest
priority to unadjusted quoted prices in active markets for identical assets or
liabilities (Level 1 measurements) and the lowest priority to unobservable
inputs (Level 3 measurements).  The three levels of the fair value
hierarchy under SFAS 157 are as follows:




Level 1: Unadjusted
      quoted prices in active markets that are accessible at the measurement
      date for identical, unrestricted assets or
  liabilities.





Level 2: Quoted prices
      in markets that are not active, or inputs that are observable either
      directly or indirectly, for substantially the full term of the asset or
      liability.





Level 3: Prices or
      valuation techniques that require inputs that are both significant to the
      fair value measurement and unobservable (i.e., supported with little or no
      market activity).




84
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
14 - FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)





An
asset’s or liability’s level within the fair value hierarchy is based on the
lowest level of input that is significant to the fair value
measurement.




For
financial assets measured at fair value on a recurring basis, the fair value
measurements by level within the fair value hierarchy used at December 31, 2008
are as follows:




Description
                                
                                December 31,
      2008
                                
                                
                                (Level
      1)
                                  Quoted
      Prices in Active Markets for Identical Assets
                                
                                
                                (Level
      2)
                                  Significant
                                  Other
                                  Observable
                                  Inputs
                                
                                
                                (Level
      3)
                                  Significant
                                  Unobservable
                                  Inputs(In
      Thousands)Securities
      available for sale
                                
                                $
                                110,247
                                
                                
                                $
                                1,010
                                
                                
                                $
                                108,146
                                
                                
                                $
                                1,091





The
following table presents a reconciliation of the securities available for sale
measured at fair value on a recurring basis using significant unobservable
inputs (Level 3) for the year ended December 31:




2008(In
      Thousands)Beginning
      balance, January 1
                          
                          $
                          1,065Total unrealized gains included
      in other comprehensive income
                          
                          
                          25Ending
      balance, December 31
                          
                          $
                          1,091





For
financial assets measured at fair value on a nonrecurring basis, the fair value
measurements by level within the fair value hierarchy used at December 31, 2008
are as follows:




Description
                                
                                December 31,
      2008
                                
                                
                                (Level
      1) Quoted Prices in Active Markets for Identical Assets
                                
                                
                                (Level
      2) Significant Other Observable Inputs
                                
                                
                                (Level
      3)
                                  Significant
                                  Unobservable
      Inputs(In
      Thousands)Impairedloans
                                
                                $
                                2,168
                                
                                
                                $
                                0
                                
                                
                                $
                                0
                                
                                
                                $
                                2,168





As
discussed above, the Company has delayed its disclosure requirements of
non-financial assets and liabilities.  Certain real estate owned with
write-downs subsequent to foreclosure andintangible assetsare carried at fair
value at the balance sheet date for which the Company has not yet adopted the
provisions of SFAS 157.


85
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
14 - FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)





The
following information should not be interpreted as an estimate of the fair value
of the entire Company since a fair value calculation is only provided for a
limited portion of the Company’s assets and liabilities.  Due to a
wide range of valuation techniques and the degree of subjectivity used in making
the estimates, comparisons between the Company’s disclosures and those of other
companies may not be meaningful.  The following methods and
assumptions were used to estimate the fair values of the Company’s financial
instruments at December 31, 2008 and 2007:




Cash
and Cash Equivalents (Carried at Cost)




The
carrying amounts reported in the balance sheet for cash and short-term
instruments approximate those assets’ fair values.




Securities
(Carried at Fair Value)




The fair
value of securities available for sale (carried at fair value) are determined by
obtaining quoted market prices on nationally recognized securities exchanges
(Level 1), or matrix pricing (Level 2), which is a mathematical technique
used widely in the industry to value debt securities without relying exclusively
on quoted market prices for the specific securities but rather by relying on the
securities’ relationship to other benchmark quoted prices.  For
certain securities which are not traded in active markets or are subject to
transfer restrictions, valuations are adjusted to reflect illiquidity and/or
non-transferability, and such adjustments are generally based on available
market evidence (Level 3).  In the absence of such evidence,
management’s best estimate is used.  Management’s best estimate
consists of both internal and external support on certain Level 3
investments.  Internal cash flow models using a present value formula
that includes assumptions market participants would use along with indicative
exit pricing obtained from broker/dealers (where available) were used to support
fair values of certain Level 3 investments.




Loans
Receivable (Carried at Cost)




The fair
values of loans are estimated using discounted cash flow analyses, using market
rates at the balance sheet date that reflect the credit and interest rate-risk
inherent in the loans.  Projected future cash flows are calculated
based upon contractual maturity or call dates, projected repayments and
prepayments of principal.  Generally, for variable rate loans that
reprice frequently and with no significant change in credit risk, fair values
are based on carrying values.




86
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
14 - FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)





Impaired
Loans (Generally Carried at Fair Value)




Impaired
loans are those that are accounted for under FASB Statement No. 114,Accounting by Creditors for
Impairment of a Loan(“SFAS 114”),in which the Bank has
measured impairment generally based on the fair value of the loan’s
collateral.  Fair value is generally determined based upon independent
third-party appraisals of the properties, or discounted cash flows based upon
the expected proceeds.  These assets are included as Level 3 fair
values, based upon the lowest level of input that is significant to the fair
value measurements.  The fair value consists of the loan balances of
$4,492,000, net of a valuation allowance of $624,000.  Additional
provisions for loan losses of $696,000 were recorded during the
period.




Restricted
Investment in Bank Stock (Carried at Cost)




The
carrying amount of restricted investment in bank stock (included in securities)
approximates fair value, and considers the limited marketability of such
securities.




Accrued
Interest Receivable and Payable (Carried at Cost)




The
carrying amount of accrued interest receivable and accrued interest payable
approximates its fair value.




Deposit
Liabilities (Carried at Cost)




The fair
values disclosed for demand deposits (e.g., interest and noninterest checking,
passbook savings and money market accounts) are, by definition, equal to the
amount payable on demand at the reporting date (i.e., their carrying
amounts).  Fair values for fixed-rate certificates of deposit are
estimated using a discounted cash flow calculation that applies interest rates
currently being offered in the market on certificates to a schedule of
aggregated expected monthly maturities on time deposits.




Short-Term
Borrowings (Carried at Cost)




The
carrying amounts of short-term borrowings approximate their fair
values.




Long-Term
Debt (Carried at Cost)




Fair
values of FHLB advances are estimated using discounted cash flow analysis, based
on quoted prices for new FHLB advances with similar credit risk characteristics,
terms and remaining maturity.  These prices obtained from this active
market represent a market value that is deemed to represent the transfer price
if the liability were assumed by a third party.




87
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
14 - FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)





Off-Balance
Sheet Financial Instruments (Disclosed at Cost)





Fair
values for the Company’s off-balance sheet financial instruments (lending
commitments and letters of credit) are based on fees currently charged in the
market to enter into similar agreements, taking into account, the remaining
terms of the agreements and the counterparties’ credit standing.




The
estimated fair values of the Company’s financial instruments were as follows at
December 31, 2008 and 2007.




December
      31, 2008
                          
                          
                          December
      31, 2007Carrying
                            Amount
                          
                          
                          Fair
                            Value
                          
                          
                          Carrying
                            Amount
                          
                          
                          Fair
                            Value(In
      Thousands)Financial
      assets:Cash and cash
      equivalents
                          
                          $
                          18,533
                          
                          
                          $
                          18,533
                          
                          
                          $
                          8,606
                          
                          
                          $
                          8,606Securities
      available-for-sale
                          
                          
                          110,247
                          
                          
                          
                          110,247
                          
                          
                          
                          112,746
                          
                          
                          
                          112,746Loans receivable,
    net
                          
                          
                          313,606
                          
                          
                          
                          364,501
                          
                          
                          
                          288,601
                          
                          
                          
                          288,983Accrued interest
      receivable
                          
                          
                          2,526
                          
                          
                          
                          2,526
                          
                          
                          
                          2,237
                          
                          
                          
                          2,237Financial
      liabilities:Deposits
                          
                          
                          371,268
                          
                          
                          
                          373,147
                          
                          
                          
                          327,430
                          
                          
                          
                          327,566Short-term
    borrowings
                          
                          
                          18,432
                          
                          
                          
                          18,432
                          
                          
                          
                          22,848
                          
                          
                          
                          22,848Long-term
    borrowings
                          
                          
                          39,691
                          
                          
                          
                          40,283
                          
                          
                          
                          38,534
                          
                          
                          
                          39,832Accrued interest
      payable
                          
                          
                          1,649
                          
                          
                          
                          1,649
                          
                          
                          
                          925
                          
                          
                          
                          925Off-balance
      sheet items:Commitments
      to grant loans
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Unfunded
      commitments under lines of credit
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Standby
      letters of credit
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -





88
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
15 - PARENT COMPANY ONLY FINANCIAL INFORMATION





Balance
      Sheets






December
      31,2008
                  
                  
                  2007(In
      Thousands)ASSETSCash
                  
                  $
                  918
                  
                  
                  $
                  535Investment
      in bank subsidiary
                  
                  
                  30,313
                  
                  
                  
                  33,357Investment
      in non-bank subsidiary
                  
                  
                  5,576
                  
                  
                  
                  5,733Due
      from subsidiary
                  
                  
                  713
                  
                  
                  
                  335Securities
      available for sale
                  
                  
                  2,102
                  
                  
                  
                  2,695Other
      assets
                  
                  
                  155
                  
                  
                  
                  150Total
      Assets
                  
                  $
                  39,777
                  
                  
                  $
                  42,805LIABILITIES
      AND STOCKHOLDERS’ EQUITYOther
      liabilities
                  
                  $
                  57
                  
                  
                  $
                  0Stockholders’
      equity:Common stock
                  
                  
                  6,683
                  
                  
                  
                  6,683Surplus
                  
                  
                  3,100
                  
                  
                  
                  3,083Retained earnings
                  
                  
                  39,375
                  
                  
                  
                  38,824Accumulated other comprehensive
      loss
                  
                  
                  (4,755
                  )
                  
                  
                  (1,390
                  )44,403
                  
                  
                  
                  47,200Treasury stock
                  
                  
                  (4,683
                  )
                  
                  
                  (4,395
                  )Total
      Stockholders’ Equity
                  
                  
                  39,720
                  
                  
                  
                  42,805Total
      Liabilities and Stockholders’ Equity
                  
                  $
                  39,777
                  
                  
                  $
                  42,805





89
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
15 - PARENT COMPANY ONLY FINANCIAL INFORMATION (CONTINUED)





Statements
      of Income




Years
      Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006(In
      Thousands)Dividends
      from bank subsidiary
                  
                  $
                  2,729
                  
                  
                  $
                  2,493
                  
                  
                  $
                  3,968Other
      income
                  
                  
                  492
                  
                  
                  
                  166
                  
                  
                  
                  263Other
      expenses
                  
                  
                  817
                  
                  
                  
                  78
                  
                  
                  
                  632,404
                  
                  
                  
                  2,581
                  
                  
                  
                  4,168Income
      tax expense
                  
                  
                  0
                  
                  
                  
                  30
                  
                  
                  
                  32.404
                  
                  
                  
                  2,551
                  
                  
                  
                  4,165Distributions
      in excess (undistributed) net income of subsidiary
                  
                  
                  635
                  
                  
                  
                  2,320
                  
                  
                  
                  (36
                  )Net
      Income
                  
                  $
                  3,039
                  
                  
                  $
                  4,871
                  
                  
                  $
                  4,129




90
 PEOPLES
FINANCIAL SERVICES CORP. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
15 - PARENT COMPANY ONLY FINANCIAL INFORMATION (CONTINUED)





Statements
      of Cash Flows




Years
      Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006(In
      Thousands)CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      income
                  
                  $
                  3,039
                  
                  
                  $
                  4,871
                  
                  
                  $
                  4,129Adjustments
      to reconcile net income to net cash provided by operating
      activities:Net
      realized losses (gains) on sales of securities
                  
                  
                  14
                  
                  
                  
                  (63
                  )
                  
                  
                  (192
                  )Other
      than temporary security impairment
                  
                  
                  388
                  
                  
                  
                  0
                  
                  
                  
                  0Stock
      option expense
                  
                  
                  1
                  
                  
                  
                  3
                  
                  
                  
                  3Distributions
      in excess as edited (undistributed) net income of
      subsidiary
                  
                  
                  (635
                  )
                  
                  
                  (2,320
                  )
                  
                  
                  (1,029
                  )(Increase)
      decrease in other assets
                  
                  
                  34
                  
                  
                  
                  (10
                  )
                  
                  
                  0Increase
      (Decrease) in due from/to subsidiary
                  
                  
                  (48
                  )
                  
                  
                  52
                  
                  
                  
                  36Net
      Cash Provided by Operating Activities
                  
                  
                  2,793
                  
                  
                  
                  2,533
                  
                  
                  
                  2,947CASH
      FLOWS PROVIDED BY INVESTING ACTIVITIESProceeds
      from sale of available for sale securities
                  
                  
                  298
                  
                  
                  
                  479
                  
                  
                  
                  889Purchase
      of available-for-sale securities
                  
                  
                  (19
                  )
                  
                  
                  (987
                  )
                  
                  
                  (152
                  )Net
      Cash Provided by (Used In) Investing Activities
                  
                  
                  279
                  
                  
                  
                  (508
                  )
                  
                  
                  737CASH
      FLOWS FROM FINANCING ACTIVITIESCash
      dividends paid
                  
                  
                  (2,417
                  )
                  
                  
                  (2,383
                  )
                  
                  
                  (2,392
                  )Proceeds
      from sale of treasury stock
                  
                  
                  234
                  
                  
                  
                  163
                  
                  
                  
                  101Purchase
      of treasury stock
                  
                  
                  (506
                  )
                  
                  
                  (94
                  )
                  
                  
                  (783
                  )Net
      Cash Used in Financing Activities
                  
                  
                  (2,689
                  )
                  
                  
                  (2,314
                  )
                  
                  
                  (3,074
                  )Increase
      (Decrease) in Cash and Cash Equivalents
                  
                  
                  383
                  
                  
                  
                  (289
                  )
                  
                  
                  610CASH
      AND CASH EQUIVALENTS - BEGINNING
                  
                  
                  535
                  
                  
                  
                  824
                  
                  
                  
                  214CASH
      AND CASH EQUIVALENTS - ENDING
                  
                  $
                  918
                  
                  
                  $
                  535
                  
                  
                  $
                  824SUPPLEMENTARY
      DISCLOSURES OF NON CASH INVESTING AND FINANCING ACTIVITIESSecurities
      acquired through transfer from subsidiary
                  
                  $
                  0
                  
                  
                  $
                  0
                  
                  
                  $
                  1,065


91


ITEM
9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE





NONE.


ITEM 9A CONTROLS AND
PROCEDURES





(a)
      Management’s annual report on internal control over financial
      reporting.




The
      management of Peoples Financial Services Corp. and subsidiaries (the
      “Company”) is responsible for designing, implementing, documenting, and
      maintaining an adequate system of internal control over financial
      reporting. An adequate system of internal control over financial reporting
      encompasses the processes and procedures that have been established by
      management to:
                  maintain records
        that accurately reflect the Company's transactions;
                    prepare financial
        statement and footnote disclosures in accordance with accounting
        principles generally accepted in the United States, that can be relied
        upon by external users;
                    prevent and detect
        unauthroized acquisitions, use, or disposition of the Company's assets
        that could have a material effect on the financial
        statements.Management
      is also responsible to perform an annual evaluation of the system of
      internal control over financial reporting, including an assessment of the
      effectiveness of that system.  Management's assessment is based
      on the criteria in Internal Control-Integrated
      Framework issued by the Committee of Sponsoring Organizations of
      the Treadway Commission (COSO).  The COSO framework identifies
      five defining characteristics of a system of internal control as
      follows:  an appropriate control environment; an adequate risk
      assessment process; sufficient control activities; satisfactory
      communication of pertinent information; and proper monitoring
      controls.
                  
                  Management
      performed an assessment of the effectiveness of its internal control over
      financial reporting in accordance with the COSO framework.  As
      part of this process, consideration was given to the potential existence
      of deficiencies in either the design or operating effectiveness of
      controls.  Based on this assessment, management believes that
      the Company maintained effective internal control over financial
      reporting, including disclosure controls and procedures, as of December
      31, 2008.  Furthermore, during the conduct of its assessment,
      management identified no material weakness in its financial reporting
      control system.
                  
                  The
      Board of Directors of the Company, through its Audit Committee, provides
      oversight to management’s conduct of the financial reporting process. The
      Audit Committee, which is composed entirely of independent directors, is
      also responsible to recommend the appointment of independent public
      accountants.  The Audit Committee also meets
      with  management,  the internal audit
      staff,  and the
      independent  public  accountants  throughout
      the year to provide assurance as to the adequacy of the financial
      reporting process and to monitor the overall scope of the work performed
      by the internal audit staff and the independent public
      accountants.
                  
                  The  consolidated  financial  statements
      of the Company have been audited by Beard Miller Company LLP, an
      independent registered public accounting firm, who was
      engaged  to  express  an
      opinion  as to
      the  fairness  of  presentation  of
      such financial  statements.  In connection therewith,
      Beard Miller Company LLP is required to form its own opinion as to
      theeffectiveness
      of those controls. Their opinion on the fairness of the financial
      statement presentation, and their opinion on internal controls over
      financial reporting are included herein.


(b)
      Attestation report of the registered public accounting
    firm.





92





REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
              
              
              
              To
      the Board of Directors and Stockholders
              Peoples
      Financial Services Corp.
              Hallstead,
      Pennsylvania
              
              We
      have audited Peoples Financial Services Corp. and subsidiaries (the
      “Company”) internal control over financial reporting as of December 31,
      2008, based on criteria established in Internal Control—Integrated
      Frameworkissued by the Committee of Sponsoring Organizations of
      the Treadway Commission (COSO).  The Company’s management is
      responsible for maintaining effective internal control over financial
      reporting and for its assessment of the effectiveness of internal control
      over financial reporting included in the accompanying Management’s Report
      on Internal Control.  Our responsibility is to express an
      opinion on the Company’s internal control over financial reporting based
      on our audit.
              
              We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (United States).  Those standards
      require that we plan and perform the audit to obtain reasonable assurance
      about whether effective internal control over financial reporting was
      maintained in all material respects.  Our audit of internal
      control over financial reporting included obtaining an understanding of
      internal control over financial reporting, assessing the risk that a
      material weakness exists, and testing and evaluating the design and
      operating effectiveness of internal control based on the assessed
      risk.  Our audit also included performing such other procedures
      as we considered necessary in the circumstances.  We believe
      that our audit provides a reasonable basis for our opinion.
              
              A
      company’s internal control over financial reporting is a process designed
      to provide reasonable assurance regarding the reliability of financial
      reporting and the preparation of financial statements for external
      purposes in accordance with generally accepted accounting
      principles.  A company’s internal control over financial
      reporting includes those policies and procedures that (1) pertain to the
      maintenance of records that, in reasonable detail, accurately and fairly
      reflect the transactions and dispositions of the assets of the company;
      (2) provide reasonable assurance that transactions are recorded as
      necessary to permit preparation of financial statements in accordance with
      generally accepted accounting principles, and that receipts and
      expenditures of the company are being made only in accordance with
      authorizations of management and directors of the company; and (3) provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use, or disposition of the company’s assets that
      could have a material effect on the financial statements.
              
              Because
      of its inherent limitations, internal control over financial reporting may
      not prevent or detect misstatements.  Also, projections of any
      evaluation of effectiveness to future periods are subject to the risk that
      controls may become inadequate because of changes in conditions, or that
      the degree of compliance with the policies or procedures may
      deteriorate.




93





In
      our opinion, the Company maintained, in all material respects, effective
      internal control over financial reporting as of December 31, 2008,
      based on criteria established in Internal Control—Integrated
      Framework issued by the Committee of Sponsoring Organizations of
      the Treadway Commission (COSO).
              
              We
      have also audited, in accordance with the standards of the Public Company
      Accounting Oversight Board (United States), the consolidated balance
      sheets of Peoples Financial Services Corp. and subsidiaries as of December
      31, 2008 and 2007 and the related consolidated statements of income,
      stockholders’ equity, and cash flows for each of the years in the three
      year period ended December 31, 2008, and our report dated March 14,
      2009, expressed an unqualified opinion.
              
              
              /s/
      BEARD MILLER COMPANY LLP
              
              
              Beard
      Miller Company LLP
              Allentown,
      Pennsylvania
              March
      14, 2009





(c)
      Changes in internal controls.





There
      were no changes in the Company’s internal controls over financial
      reporting that occurred during the fourth fiscal quarter ending December
      31, 2008 that have materially affected, or are reasonably likely to
      materially affect, the Company’s internal controls over financial
      reporting.





ITEM
9B OTHER INFORMATION





NONE.




94


PART
III





ITEM 10 DIRECTORS, EXECUTIVE OFFICERS
AND CORPORATE GOVERNANCE


This
      item is incorporated by reference under Section “Governance of the
      Company” under the previously submitted document DEF 14A Proxy Statement
      filed with the SEC.





ITEM
11 EXECUTIVE COMPENSATION


This
      item is incorporated by reference under Section “Compensation Discussion
      and Analysis” under the previously submitted document DEF 14A Proxy
      Statement filed with the SEC.





ITEM 12 SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS


This
      item is incorporated by reference under Section “Share Ownership of
      Management and Directors” under the previously submitted document DEF 14A
      Proxy Statement filed with the SEC.





ITEM
13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE


This
      item is incorporated by reference under Section “Compensation Discussion
      and Analysis” under the previously submitted document DEF 14A Proxy
      Statement filed with the SEC.





ITEM 14 PRINCIPAL ACCOUNTANT FEES AND
SERVICES


This
      item is incorporated by reference under Section “Report of the Audit
      Committee” under the previously submitted document DEF 14A Proxy Statement
      filed with the SEC.





95


PART IV





ITEM 15 EXHIBITS AND FINANCIAL
STATEMENT SCHEDULES


(3.1)
            
            Articles
      of Incorporation of Peoples Financial Services Corp. *;(3.2)
            
            Bylaws
      of Peoples Financial Services Corp. as amended **;(10.4)
            
            Termination
      Agreement dated January 1, 1997, between Debra E. Dissinger and Peoples
      Financial Services Corp.*;(10.6)
            
            Supplemental
      Executive Retirement Plan Agreement, dated December 3, 2004, for Debra E.
      Dissinger***;(10.7)
            
            Supplemental
      Director Retirement Plan Agreement, dated December 3, 2004, for all
      Non-Employee Directors of the Company***;(10.9)
            
            Amendment
      to Supplemental Executive Retirement Plan Agreement, dated December 30,
      2005, for Debra E. Dissinger****;(10.10)
            
            Amendment
      to Supplemental Director Retirement Plan Agreement, dated December 30,
      2005, for all Non-Employee Directors of the
Company****;(10.11)
            
            Termination
      Agreement dated January 1, 2007, between Stephen N. Lawrenson and Peoples
      Financial Services Corp.******;(10.12)
            
            Termination
      Agreement dated January 1, 2007, between Joseph M. Ferretti and Peoples
      Financial Services Corp.******;(10.13)
            
            Employment
      Agreement dated February, 2007, between Richard S. Lochen, Jr. and Peoples
      Financial Services Corp.*****;(11)
            
            The
      statement regarding computation of per-share earnings required by this
      exhibit is contained in Note 1 to the consolidated financial statements
      captioned “Earnings Per Share”;(14)
            
            Code
      of Ethics, as amended********;(21)
            
            Subsidiaries
      of Peoples Financial Services Corp.*******;(31.1)
            
            Certification
      of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a), filed
      herewith;(31.2)
            
            Certification
      of Principal Financial Officer pursuant to Rule 13a-14(a)/15d-14(a), filed
      herewith;(32.1)
            
            Certification
      of Chief Executive Officer pursuant to Section 1350 of Sarbanes-Oxley Act
      of 2002, filed herewith; and(32.2)
            
            Certification
      of Principal Financial Officer pursuant to Section 1350 of Sarbanes-Oxley
      Act of 2002, filed herewith.*
            Incorporated
      by reference to the Corporation’s Registration Statement on Form 10 as
      filed with the U.S. Securities and Exchange Commission on March 4,
      1998.**
            Incorporated
      by reference to the Corporation’s Exhibit 3.2 on Form 10-Q filed with the
      U.S. Securities and Exchange Commission on November 8,
    2004.***
            Incorporated
      by reference to the Corporation’s Exhibits 10.6 and 10.7 on Form 10-K
      filed with the U.S. Securities and Exchange Commission on March 15,
      2005.****
            Incorporated
      by reference to the Corporation’s Exhibits 10.9, and 10.10 on Form 10-K
      filed with the U.S. Securities and Exchange Commission on March 15,
      2006.*****
            Incorporated
      by reference to the Corporation’s Exhibit 10.13 on Form 8K filed with the
      U.S. Securities and Exchange Commission on February 16,
    2007.******
            Incorporated
      by reference to the Corporation’s Exhibits 10.11 and 10.12 on Form 10-Q
      filed with the U.S. Securities and Exchange Commission on May 10,
      2007.*******
            Incorporated
      by reference to the Corporation’s Exhibit 21 on Form 10-Q filed with the
      U.S. Securities and Exchange Commission on August 9,
  2007.********
            Incorporated
      by reference to the Corporation’s Exhibit 14 as filed on Form 10Q with the
      U.S. Securities and Exchange Commission on August 11,
  2008.




96


SIGNATURES





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





PEOPLES
FINANCIAL SERVICES CORP.





BY:
                  /s/
                  William
      E. Aubrey II
                    William
      E Aubrey II, Chairman, Board of Directors/s/
                  Richard
      S. Lochen, Jr.
                    Richard
      S. Lochen, Jr., President/CEO/s/
                  Debra
      E. Dissinger
                    Debra
      E. Dissinger, Executive Vice President/s/
                  Frederick
      J. Malloy
                    Frederick
      J. Malloy, VP/Controller/s/
                  Russell
      D. Shurtleff, Esq.
                    Russell
      D. Shurtleff, Vice Chairman, Board of Directors/s/
                  George
      H. Stover, Jr.
                    George
      H. Stover, Jr. Member, Board of Directors/s/
                  John
      W. Ord
                    John
      W. Ord, Member, Board of Directors/s/
                  Ronald
      G. Kukuchka
                    Ronald
      G. Kukuchka, Member, Board of Directors




97