UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
DC 20549





FORM
10-Q





(Mark
One)


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





For the quarterly period ended    September 30, 2010


OR


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





For the
transition period from _____________________________ to
_____________________________





Commission
file number 0-17706





QNB
      Corp.(Exact
      Name of Registrant as Specified in Its
Charter)





Pennsylvania
            23-2318082(State
      or Other Jurisdiction of Incorporation or Organization)
            (I.R.S.
      Employer Identification No.)15 North Third Street, P.O. Box 9005 Quakertown,
      PA
            18951-9005(Address
      of Principal Executive Offices)
            (Zip
      Code)





Registrant's
Telephone Number, Including Area Code   (215)
538-5600





Not ApplicableFormer
      Name, Former Address and Former Fiscal Year, if Changed Since Last
      Report.





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





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





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


Large accelerated filer ̈
              Accelerated
      filer  ̈Non-accelerated
      filer  ̈
              Smaller Reporting Companyþ




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


Yes ̈No þ





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





Class
              
              Outstanding
      at November 3, 2010Common
      Stock, par value $0.625
              
              3,117,993







QNB
CORP. AND SUBSIDIARY


FORM
10-Q


QUARTER
ENDED SEPTEMBER 30, 2010





INDEX





PAGEPART
      I - FINANCIAL INFORMATIONITEM
      1.
                      CONSOLIDATED
      FINANCIAL STATEMENTS (Unaudited)Consolidated
      Balance Sheets at September 30, 2010 and December 31, 2009
                      3Consolidated
      Statements of Income for the Three and Nine Months Ended September 30,
      2010 and 2009
                      4Consolidated
      Statement of Shareholders’ Equity for the Nine Months Ended September 30,
      2010
                      5Consolidated
      Statements of Cash Flows for the Nine Months Ended September 30, 2010 and
      2009
                      6Notes
      to Consolidated Financial Statements
                      7ITEM
      2.
                      MANAGEMENT'S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS
                      27ITEM
      3.
                      QUANTITATIVE AND QUALITATIVE
      DISCLOSURE ABOUTMARKET
      RISK
                      58ITEM
      4.
                      CONTROLS
      AND PROCEDURES
                      58PART
      II - OTHER INFORMATIONITEM
      1.
                      LEGAL
      PROCEEDINGS
                      59ITEM
      1A.
                      RISK
      FACTORS
                      59ITEM
      2.
                      UNREGISTERED
      SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
                      59ITEM
      3.
                      DEFAULTS
      UPON SENIOR SECURITIES
                      59ITEM
      4.
                      (REMOVED
      AND RESERVED)
                      59ITEM
      5.
                      OTHER
      INFORMATION
                      59ITEM
      6.
                      EXHIBITS
                      60SIGNATURES
                      
                      61CERTIFICATIONS




- 2
-





QNB
Corp. and Subsidiary


CONSOLIDATED
BALANCE SHEETS


(in
      thousands, except share data)(unaudited)September
      30,
                                              
                                              
                                              December
      31,2010
                                              
                                              
                                              2009AssetsCash
      and due from banks
                                              
                                              $
                                              8,014
                                              
                                              
                                              $
                                              8,841Interest-bearing
      deposits in banks
                                              
                                              
                                              4,052
                                              
                                              
                                              
                                              22,158Total
      cash and cash equivalents
                                              
                                              
                                              12,066
                                              
                                              
                                              
                                              30,999Investment
      securitiesAvailable-for-sale
      (amortized cost $272,574 and $254,251)
                                              
                                              
                                              279,251
                                              
                                              
                                              
                                              256,862Held-to-maturity
      (fair value $2,944 and $3,471)
                                              
                                              
                                              2,847
                                              
                                              
                                              
                                              3,347Restricted
      investment in bank stocks
                                              
                                              
                                              2,291
                                              
                                              
                                              
                                              2,291Loans
      held-for-sale
                                              
                                              
                                              968
                                              
                                              
                                              
                                              534Loans
      receivable
                                              
                                              
                                              477,940
                                              
                                              
                                              
                                              449,421Allowance
      for loan losses
                                              
                                              
                                              (8,132
                                              )
                                              
                                              
                                              (6,217
                                              )Net
      loans
                                              
                                              
                                              469,808
                                              
                                              
                                              
                                              443,204Bank-owned
      life insurance
                                              
                                              
                                              9,324
                                              
                                              
                                              
                                              9,109Premises
      and equipment, net
                                              
                                              
                                              6,506
                                              
                                              
                                              
                                              6,248Accrued
      interest receivable
                                              
                                              
                                              2,968
                                              
                                              
                                              
                                              2,848Other
      assets
                                              
                                              
                                              5,207
                                              
                                              
                                              
                                              6,984Total
      assets
                                              
                                              $
                                              791,236
                                              
                                              
                                              $
                                              762,426LiabilitiesDepositsDemand,
      non-interest bearing
                                              
                                              $
                                              53,100
                                              
                                              
                                              $
                                              53,930Interest-bearing
      demand
                                              
                                              
                                              128,907
                                              
                                              
                                              
                                              120,554Money
      market
                                              
                                              
                                              76,987
                                              
                                              
                                              
                                              70,165Savings
                                              
                                              
                                              103,794
                                              
                                              
                                              
                                              68,358Time
                                              
                                              
                                              208,600
                                              
                                              
                                              
                                              215,155Time
      of $100,000 or more
                                              
                                              
                                              102,859
                                              
                                              
                                              
                                              105,941Total
      deposits
                                              
                                              
                                              674,247
                                              
                                              
                                              
                                              634,103Short-term
      borrowings
                                              
                                              
                                              31,173
                                              
                                              
                                              
                                              28,433Long-term
      debt
                                              
                                              
                                              20,311
                                              
                                              
                                              
                                              35,000Accrued
      interest payable
                                              
                                              
                                              1,174
                                              
                                              
                                              
                                              1,565Other
      liabilities
                                              
                                              
                                              1,649
                                              
                                              
                                              
                                              6,899Total
      liabilities
                                              
                                              
                                              728,554
                                              
                                              
                                              
                                              706,000Shareholders'
      EquityCommon
      stock, par value $0.625 per share;authorized
      10,000,000 shares; 3,278,975 shares and 3,257,794 shares
      issued;3,114,406
      and 3,093,225 shares outstanding
                                              
                                              
                                              2,049
                                              
                                              
                                              
                                              2,036Surplus
                                              
                                              
                                              10,606
                                              
                                              
                                              
                                              10,221Retained
      earnings
                                              
                                              
                                              48,096
                                              
                                              
                                              
                                              44,922Accumulated
      other comprehensive income, net
                                              
                                              
                                              4,407
                                              
                                              
                                              
                                              1,723Treasury
      stock, at cost; 164,569 shares
                                              
                                              
                                              (2,476
                                              )
                                              
                                              
                                              (2,476
                                              )Total
      shareholders' equity
                                              
                                              
                                              62,682
                                              
                                              
                                              
                                              56,426Total
      liabilities and shareholders' equity
                                              
                                              $
                                              791,236
                                              
                                              
                                              $
                                              762,426





The
accompanying notes are an integral part of the unaudited consolidated financial
statements.


- 3
-





QNB
Corp. and Subsidiary


CONSOLIDATED
STATEMENTS OF INCOME


(in
      thousands, except share data)(unaudited)Three
      Months
                                                      
                                                      
                                                      Nine
      MonthsEnded
      September 30,
                                                      
                                                      
                                                      Ended
      September 30,2010
                                                      
                                                      
                                                      2009
                                                      
                                                      
                                                      2010
                                                      
                                                      
                                                      2009Interest
      IncomeInterest
      and fees on loans
                                                      
                                                      $
                                                      6,847
                                                      
                                                      
                                                      $
                                                      6,389
                                                      
                                                      
                                                      $
                                                      19,841
                                                      
                                                      
                                                      $
                                                      18,451Interest
      and dividends on investment securities:Taxable
                                                      
                                                      
                                                      1,641
                                                      
                                                      
                                                      
                                                      1,981
                                                      
                                                      
                                                      
                                                      5,330
                                                      
                                                      
                                                      
                                                      6,361Tax-exempt
                                                      
                                                      
                                                      619
                                                      
                                                      
                                                      
                                                      571
                                                      
                                                      
                                                      
                                                      1,794
                                                      
                                                      
                                                      
                                                      1,609Interest
      on Federal funds sold
                                                      
                                                      
                                                      –
                                                      
                                                      
                                                      
                                                      –
                                                      
                                                      
                                                      
                                                      –
                                                      
                                                      
                                                      
                                                      2Interest
      on interest-bearing balances and other interest income
                                                      
                                                      
                                                      10
                                                      
                                                      
                                                      
                                                      5
                                                      
                                                      
                                                      
                                                      29
                                                      
                                                      
                                                      
                                                      8Total
      interest income
                                                      
                                                      
                                                      9,117
                                                      
                                                      
                                                      
                                                      8,946
                                                      
                                                      
                                                      
                                                      26,994
                                                      
                                                      
                                                      
                                                      26,431Interest
      ExpenseInterest
      on depositsInterest-bearing
      demand
                                                      
                                                      
                                                      242
                                                      
                                                      
                                                      
                                                      210
                                                      
                                                      
                                                      
                                                      709
                                                      
                                                      
                                                      
                                                      537Money
      market
                                                      
                                                      
                                                      128
                                                      
                                                      
                                                      
                                                      184
                                                      
                                                      
                                                      
                                                      455
                                                      
                                                      
                                                      
                                                      525Savings
                                                      
                                                      
                                                      197
                                                      
                                                      
                                                      
                                                      44
                                                      
                                                      
                                                      
                                                      518
                                                      
                                                      
                                                      
                                                      103Time
                                                      
                                                      
                                                      1,033
                                                      
                                                      
                                                      
                                                      1,684
                                                      
                                                      
                                                      
                                                      3,427
                                                      
                                                      
                                                      
                                                      5,352Time
      of $100,000 or more
                                                      
                                                      
                                                      548
                                                      
                                                      
                                                      
                                                      851
                                                      
                                                      
                                                      
                                                      1,771
                                                      
                                                      
                                                      
                                                      2,681Interest
      on short-term borrowings
                                                      
                                                      
                                                      84
                                                      
                                                      
                                                      
                                                      64
                                                      
                                                      
                                                      
                                                      204
                                                      
                                                      
                                                      
                                                      173Interest
      on long-term debt
                                                      
                                                      
                                                      244
                                                      
                                                      
                                                      
                                                      382
                                                      
                                                      
                                                      
                                                      810
                                                      
                                                      
                                                      
                                                      1,132Total
      interest expense
                                                      
                                                      
                                                      2,476
                                                      
                                                      
                                                      
                                                      3,419
                                                      
                                                      
                                                      
                                                      7,894
                                                      
                                                      
                                                      
                                                      10,503Net
      interest income
                                                      
                                                      
                                                      6,641
                                                      
                                                      
                                                      
                                                      5,527
                                                      
                                                      
                                                      
                                                      19,100
                                                      
                                                      
                                                      
                                                      15,928Provision
      for loan losses
                                                      
                                                      
                                                      1,200
                                                      
                                                      
                                                      
                                                      1,500
                                                      
                                                      
                                                      
                                                      2,600
                                                      
                                                      
                                                      
                                                      2,600Net
      interest income after provision for loan losses
                                                      
                                                      
                                                      5,441
                                                      
                                                      
                                                      
                                                      4,027
                                                      
                                                      
                                                      
                                                      16,500
                                                      
                                                      
                                                      
                                                      13,328Non-Interest
      IncomeTotal
      other-than-temporary impairment losses on investment
      securities
                                                      
                                                      
                                                      (51
                                                      )
                                                      
                                                      
                                                      (2,279
                                                      )
                                                      
                                                      
                                                      (304
                                                      )
                                                      
                                                      
                                                      (2,850
                                                      )Less:
      Portion of loss recognized in other comprehensive income (before
      taxes)
                                                      
                                                      
                                                      –
                                                      
                                                      
                                                      
                                                      1,526
                                                      
                                                      
                                                      
                                                      27
                                                      
                                                      
                                                      
                                                      1,574Net
      other-than-temporary impairment losses on investment
      securities
                                                      
                                                      
                                                      (51
                                                      )
                                                      
                                                      
                                                      (753
                                                      )
                                                      
                                                      
                                                      (277
                                                      )
                                                      
                                                      
                                                      (1,276
                                                      )Net
      gain on sale of investment securities
                                                      
                                                      
                                                      4
                                                      
                                                      
                                                      
                                                      103
                                                      
                                                      
                                                      
                                                      299
                                                      
                                                      
                                                      
                                                      346Net
      (loss) gain on investment securities
                                                      
                                                      
                                                      (47
                                                      )
                                                      
                                                      
                                                      (650
                                                      )
                                                      
                                                      
                                                      22
                                                      
                                                      
                                                      
                                                      (930
                                                      )Fees
      for services to customers
                                                      
                                                      
                                                      392
                                                      
                                                      
                                                      
                                                      470
                                                      
                                                      
                                                      
                                                      1,203
                                                      
                                                      
                                                      
                                                      1,288ATM
      and debit card
                                                      
                                                      
                                                      317
                                                      
                                                      
                                                      
                                                      263
                                                      
                                                      
                                                      
                                                      902
                                                      
                                                      
                                                      
                                                      747Bank-owned
      life insurance
                                                      
                                                      
                                                      67
                                                      
                                                      
                                                      
                                                      66
                                                      
                                                      
                                                      
                                                      199
                                                      
                                                      
                                                      
                                                      203Mortgage
      servicing fees
                                                      
                                                      
                                                      28
                                                      
                                                      
                                                      
                                                      28
                                                      
                                                      
                                                      
                                                      83
                                                      
                                                      
                                                      
                                                      89Net
      gain on sale of loans
                                                      
                                                      
                                                      81
                                                      
                                                      
                                                      
                                                      132
                                                      
                                                      
                                                      
                                                      298
                                                      
                                                      
                                                      
                                                      534Other
                                                      
                                                      
                                                      166
                                                      
                                                      
                                                      
                                                      205
                                                      
                                                      
                                                      
                                                      456
                                                      
                                                      
                                                      
                                                      383Total
      non-interest income
                                                      
                                                      
                                                      1,004
                                                      
                                                      
                                                      
                                                      514
                                                      
                                                      
                                                      
                                                      3,163
                                                      
                                                      
                                                      
                                                      2,314Non-Interest
      ExpenseSalaries
      and employee benefits
                                                      
                                                      
                                                      2,409
                                                      
                                                      
                                                      
                                                      2,115
                                                      
                                                      
                                                      
                                                      6,713
                                                      
                                                      
                                                      
                                                      6,271Net
      occupancy
                                                      
                                                      
                                                      386
                                                      
                                                      
                                                      
                                                      324
                                                      
                                                      
                                                      
                                                      1,115
                                                      
                                                      
                                                      
                                                      1,012Furniture
      and equipment
                                                      
                                                      
                                                      295
                                                      
                                                      
                                                      
                                                      290
                                                      
                                                      
                                                      
                                                      865
                                                      
                                                      
                                                      
                                                      895Marketing
                                                      
                                                      
                                                      155
                                                      
                                                      
                                                      
                                                      125
                                                      
                                                      
                                                      
                                                      515
                                                      
                                                      
                                                      
                                                      489Third
      party services
                                                      
                                                      
                                                      263
                                                      
                                                      
                                                      
                                                      218
                                                      
                                                      
                                                      
                                                      826
                                                      
                                                      
                                                      
                                                      715Telephone,
      postage and supplies
                                                      
                                                      
                                                      157
                                                      
                                                      
                                                      
                                                      147
                                                      
                                                      
                                                      
                                                      456
                                                      
                                                      
                                                      
                                                      452State
      taxes
                                                      
                                                      
                                                      143
                                                      
                                                      
                                                      
                                                      131
                                                      
                                                      
                                                      
                                                      422
                                                      
                                                      
                                                      
                                                      399FDIC
      insurance premiums
                                                      
                                                      
                                                      268
                                                      
                                                      
                                                      
                                                      235
                                                      
                                                      
                                                      
                                                      779
                                                      
                                                      
                                                      
                                                      967Other
                                                      
                                                      
                                                      402
                                                      
                                                      
                                                      
                                                      341
                                                      
                                                      
                                                      
                                                      1,146
                                                      
                                                      
                                                      
                                                      1,039Total
      non-interest expense
                                                      
                                                      
                                                      4,478
                                                      
                                                      
                                                      
                                                      3,926
                                                      
                                                      
                                                      
                                                      12,837
                                                      
                                                      
                                                      
                                                      12,239Income
      before income taxes
                                                      
                                                      
                                                      1,967
                                                      
                                                      
                                                      
                                                      615
                                                      
                                                      
                                                      
                                                      6,826
                                                      
                                                      
                                                      
                                                      3,403Provision
      (benefit) for income taxes
                                                      
                                                      
                                                      349
                                                      
                                                      
                                                      
                                                      (56
                                                      )
                                                      
                                                      
                                                      1,419
                                                      
                                                      
                                                      
                                                      411Net
      Income
                                                      
                                                      $
                                                      1,618
                                                      
                                                      
                                                      $
                                                      671
                                                      
                                                      
                                                      $
                                                      5,407
                                                      
                                                      
                                                      $
                                                      2,992Earnings
      Per Share - Basic
                                                      
                                                      $
                                                      0.52
                                                      
                                                      
                                                      $
                                                      0.22
                                                      
                                                      
                                                      $
                                                      1.74
                                                      
                                                      
                                                      $
                                                      0.97Earnings
      Per Share - Diluted
                                                      
                                                      $
                                                      0.52
                                                      
                                                      
                                                      $
                                                      0.22
                                                      
                                                      
                                                      $
                                                      1.74
                                                      
                                                      
                                                      $
                                                      0.96Cash
      Dividends Per Share
                                                      
                                                      $
                                                      0.24
                                                      
                                                      
                                                      $
                                                      0.24
                                                      
                                                      
                                                      $
                                                      0.72
                                                      
                                                      
                                                      $
                                                      0.72





The
accompanying notes are an integral part of the unaudited consolidated financial
statements.


- 4
-





QNB
Corp. and Subsidiary


CONSOLIDATED
STATEMENT OF SHAREHOLDERS' EQUITY




AccumulatedNumber
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    Other(in
      thousands, except share data)
                                                    
                                                    of
      Shares
                                                    
                                                    
                                                    Common
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    Retained
                                                    
                                                    
                                                    Comprehesive
                                                    
                                                    
                                                    Treasury(unaudited)
                                                    
                                                    Outstanding
                                                    
                                                    
                                                    Stock
                                                    
                                                    
                                                    Surplus
                                                    
                                                    
                                                    Earnings
                                                    
                                                    
                                                    Income
                                                    
                                                    
                                                    Stock
                                                    
                                                    
                                                    TotalBalance,
      December 31, 2009
                                                    
                                                    
                                                    3,093,225
                                                    
                                                    
                                                    $
                                                    2,036
                                                    
                                                    
                                                    $
                                                    10,221
                                                    
                                                    
                                                    $
                                                    44,922
                                                    
                                                    
                                                    $
                                                    1,723
                                                    
                                                    
                                                    $
                                                    (2,476
                                                    )
                                                    
                                                    $
                                                    56,426Comprehensive
      income:Net
      Income
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    5,407
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    5,407Other
      comprehensive income
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    2,684
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    2,684Total
      comprehensive income
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    8,091Cash
      dividends paid ($0.72 per share)
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    (2,233
                                                    )
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    (2,233
                                                    )Stock
      issued - employee stock purchase plan
                                                    
                                                    
                                                    2,253
                                                    
                                                    
                                                    
                                                    1
                                                    
                                                    
                                                    
                                                    33
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    34Stock
      issued in connection with dividend reinvestment and stock purchase
      plan
                                                    
                                                    
                                                    17,708
                                                    
                                                    
                                                    
                                                    11
                                                    
                                                    
                                                    
                                                    317
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    328Stock
      issued for options exercised
                                                    
                                                    
                                                    1,220
                                                    
                                                    
                                                    
                                                    1
                                                    
                                                    
                                                    
                                                    (1
                                                    )
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –Stock-based
      compensation expense
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    36
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    –
                                                    
                                                    
                                                    
                                                    36Balance,
      September 30, 2010
                                                    
                                                    
                                                    3,114,406
                                                    
                                                    
                                                    $
                                                    2,049
                                                    
                                                    
                                                    $
                                                    10,606
                                                    
                                                    
                                                    $
                                                    48,096
                                                    
                                                    
                                                    $
                                                    4,407
                                                    
                                                    
                                                    $
                                                    (2,476
                                                    )
                                                    
                                                    $
                                                    62,682





The
accompanying notes are an integral part of the unaudited consolidated financial
statements.


- 5
-


QNB
Corp. and Subsidiary


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(in
      thousands)
                                                                  (unaudited)Nine
      Months Ended September 30,
                                                                
                                                                2010
                                                                
                                                                
                                                                2009Operating
      ActivitiesNet
      income
                                                                
                                                                $
                                                                5,407
                                                                
                                                                
                                                                $
                                                                2,992Adjustments
      to reconcile net income to net cash provided by operating
      activitiesDepreciation
      and amortization
                                                                
                                                                
                                                                606
                                                                
                                                                
                                                                
                                                                655Provision
      for loan losses
                                                                
                                                                
                                                                2,600
                                                                
                                                                
                                                                
                                                                2,600Net
      securities (gains) losses
                                                                
                                                                
                                                                (22
                                                                )
                                                                
                                                                
                                                                930Net
      gain on sale of loans
                                                                
                                                                
                                                                (298
                                                                )
                                                                
                                                                
                                                                (534
                                                                )Net
      loss on disposal of premises and equipment
                                                                
                                                                
                                                                1
                                                                
                                                                
                                                                
                                                                –Net
      loss on sale of repossessed assets and other real estate
    owned
                                                                
                                                                
                                                                6
                                                                
                                                                
                                                                
                                                                117Proceeds
      from sales of residential mortgages
                                                                
                                                                
                                                                7,057
                                                                
                                                                
                                                                
                                                                22,954Originations
      of residential mortgages held-for-sale
                                                                
                                                                
                                                                (7,193
                                                                )
                                                                
                                                                
                                                                (22,908
                                                                )Income
      on bank-owned life insurance
                                                                
                                                                
                                                                (199
                                                                )
                                                                
                                                                
                                                                (203
                                                                )Life
      insurance premiums
                                                                
                                                                
                                                                (15
                                                                )
                                                                
                                                                
                                                                (15
                                                                )Stock-based
      compensation expense
                                                                
                                                                
                                                                36
                                                                
                                                                
                                                                
                                                                41Deferred
      income tax benefit
                                                                
                                                                
                                                                (707
                                                                )
                                                                
                                                                
                                                                (841
                                                                )Net
      increase in income taxes payable
                                                                
                                                                
                                                                85
                                                                
                                                                
                                                                
                                                                321Net
      increase in accrued interest receivable
                                                                
                                                                
                                                                (120
                                                                )
                                                                
                                                                
                                                                (115
                                                                )Amortization
      of mortgage servicing rights and identifiable intangible
      assets
                                                                
                                                                
                                                                73
                                                                
                                                                
                                                                
                                                                52Net
      amortization (accretion) of premiums and discounts on investment
      securities
                                                                
                                                                
                                                                756
                                                                
                                                                
                                                                
                                                                111Net
      (decrease) increase in accrued interest payable
                                                                
                                                                
                                                                (391
                                                                )
                                                                
                                                                
                                                                726Decrease
      (increase) in other assets
                                                                
                                                                
                                                                907
                                                                
                                                                
                                                                
                                                                (7
                                                                )Decrease
      in other liabilities
                                                                
                                                                
                                                                (271
                                                                )
                                                                
                                                                
                                                                (266
                                                                )Net
      cash provided by operating activities
                                                                
                                                                
                                                                8,318
                                                                
                                                                
                                                                
                                                                6,610Investing
      ActivitiesProceeds
      from maturities and calls of investment securitiesavailable-for-sale
                                                                
                                                                
                                                                99,037
                                                                
                                                                
                                                                
                                                                68,084held-to-maturity
                                                                
                                                                
                                                                500
                                                                
                                                                
                                                                
                                                                250Proceeds
      from sales of investment securitiesavailable-for-sale
                                                                
                                                                
                                                                3,476
                                                                
                                                                
                                                                
                                                                7,161Purchase
      of investment securitiesavailable-for-sale
                                                                
                                                                
                                                                (126,568
                                                                )
                                                                
                                                                
                                                                (101,777
                                                                )Net
      increase in loans
                                                                
                                                                
                                                                (29,338
                                                                )
                                                                
                                                                
                                                                (35,359
                                                                )Net
      purchases of premises and equipment
                                                                
                                                                
                                                                (865
                                                                )
                                                                
                                                                
                                                                (282
                                                                )Proceeds
      from sale of repossessed assets and other real estate
owned
                                                                
                                                                
                                                                183
                                                                
                                                                
                                                                
                                                                689Net
      cash used by investing activities
                                                                
                                                                
                                                                (53,575
                                                                )
                                                                
                                                                
                                                                (61,234
                                                                )Financing
      ActivitiesNet
      decrease in non-interest bearing deposits
                                                                
                                                                
                                                                (830
                                                                )
                                                                
                                                                
                                                                (3,167
                                                                )Net
      increase in interest-bearing non-maturity deposits
                                                                
                                                                
                                                                50,611
                                                                
                                                                
                                                                
                                                                42,589Net
      (decrease) increase in time deposits
                                                                
                                                                
                                                                (9,637
                                                                )
                                                                
                                                                
                                                                14,947Net
      increase in short-term borrowings
                                                                
                                                                
                                                                2,740
                                                                
                                                                
                                                                
                                                                5,156Proceeds
      from issuance of long-term debt
                                                                
                                                                
                                                                311
                                                                
                                                                
                                                                
                                                                –Repayments
      of long-term debt
                                                                
                                                                
                                                                (15,000
                                                                )
                                                                
                                                                
                                                                –Tax
      benefit from employee stock transactions
                                                                
                                                                
                                                                –
                                                                
                                                                
                                                                
                                                                6Cash
      dividends paid
                                                                
                                                                
                                                                (2,119
                                                                )
                                                                
                                                                
                                                                (2,229
                                                                )Purchase
      of treasury stock
                                                                
                                                                
                                                                –
                                                                
                                                                
                                                                
                                                                (866
                                                                )Proceeds
      from issuance of common stock
                                                                
                                                                
                                                                248
                                                                
                                                                
                                                                
                                                                56Net
      cash provided by financing activities
                                                                
                                                                
                                                                26,324
                                                                
                                                                
                                                                
                                                                56,492(Decrease)
      increase in cash and cash equivalents
                                                                
                                                                
                                                                (18,933
                                                                )
                                                                
                                                                
                                                                1,868Cash
      and cash equivalents at beginning of year
                                                                
                                                                
                                                                30,999
                                                                
                                                                
                                                                
                                                                16,451Cash
      and cash equivalents at end of period
                                                                
                                                                $
                                                                12,066
                                                                
                                                                
                                                                $
                                                                18,319Supplemental
      Cash Flow DisclosuresInterest
      paid
                                                                
                                                                $
                                                                8,285
                                                                
                                                                
                                                                $
                                                                9,777Income
      taxes paid
                                                                
                                                                
                                                                2,040
                                                                
                                                                
                                                                
                                                                909Non-Cash
      TransactionsTransfer
      of loans to repossessed assets and other real estate owned
                                                                
                                                                
                                                                134
                                                                
                                                                
                                                                
                                                                615





The
accompanying notes are an integral part of the unaudited consolidated financial
statements.


- 6
-





QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





1.
BASIS OF PRESENTATION





The
accompanying unaudited consolidated financial statements include the accounts of
QNB Corp. and its wholly-owned subsidiary, QNB Bank (the Bank). The consolidated
entity is referred to herein as “QNB” or the “Company”. All significant
intercompany accounts and transactions are eliminated in the consolidated
financial statements.





These
consolidated financial statements should be read in conjunction with the audited
consolidated financial statements and notes thereto included in QNB's 2009
Annual Report incorporated in the Form 10-K. Operating results for the three-
and nine-month periods ended September 30, 2010 are not necessarily indicative
of the results that may be expected for the year ending December 31,
2010.





The
unaudited consolidated financial statements reflect all adjustments which, in
the opinion of management, are necessary for a fair presentation of the results
of operations for the interim periods and are of a normal and recurring
nature.





Tabular
information, other than share and per share data, is presented in thousands of
dollars.





In
preparing the consolidated financial statements, management is required to make
estimates and assumptions that affect the reported amounts of assets and
liabilities at the dates of the consolidated financial statements and the
reported amounts of revenues and expenses during the reporting periods. Actual
results could differ from such estimates.





The
Company has evaluated events and transactions occurring subsequent to the
balance sheet date of September 30, 2010, for items that should potentially be
recognized or disclosed in these financial statements.





2.
RECENT ACCOUNTING PRONOUNCEMENTS





In
October 2009, the Financial Accounting Standards Board (FASB) issued Accounting
Standards Update (ASU) 2009-16, Transfers and Servicing (Topic 860)
– Accounting for Transfers of Financial Assets. The amendments in this
update improve financial reporting by eliminating the exceptions for qualifying
special-purpose entities from the consolidation guidance and the exception that
permitted sale accounting for certain mortgage securitizations when a transferor
has not surrendered control over the transferred financial assets. In addition,
the amendments require enhanced disclosures about the risks that a transferor
continues to be exposed to because of its continuing involvement in transferred
financial assets. Comparability and consistency in accounting for transferred
financial assets will also be improved through clarifications of the
requirements for isolation and limitations on portions of financial assets that
are eligible for sale accounting. This update is effective at the start of a
reporting entity’s first fiscal year beginning after November 15, 2009. Early
application is not permitted. The adoption of ASU 2009-16 did not have a
material impact on the Company’s financial position or results of
operations.





The FASB
has issued ASU 2010-06, Fair
Value Measurements and Disclosures (Topic 820): Improving Disclosure about Fair
Value Measurements. This ASU requires some additional disclosures and
clarifies some existing disclosure requirements about fair value measurements as
set forth in Codification Subtopic 820-10. The FASB‘s objective is to improve
these disclosures and, thus, increase transparency in financial reporting.
Specifically, ASU 2010-06 amends Codification Subtopic 820-10 to now
require:


·
            A
      reporting entity to disclose separately the amounts of significant
      transfers in and out of Level 1 and Level 2 fair value measurements and
      describe the reasons for the transfers;
and


·
            In
      the reconciliation for fair value measurements using significant
      unobservable inputs, a reporting entity should present separately
      information about purchases, sales, issuances, and
      settlements.


- 7
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





2.
RECENT ACCOUNTING PRONOUNCEMENTS (Continued)





In
addition, ASU 2010-06 clarifies the requirements of the following existing
disclosures:


·
            For
      purposes of reporting fair value measurements for each class of assets and
      liabilities, a reporting entity needs to use judgment in determining the
      appropriate classes of assets and liabilities;
  and


·
            A
      reporting entity should provide disclosures about the valuation techniques
      and inputs used to measure fair value for both recurring and nonrecurring
      fair value measurements.


ASU
2010-06 is effective for interim and annual reporting periods beginning after
December 15, 2009, except for the disclosures about purchases, sales, issuance,
and settlements in the roll forward of activity in Level 3 fair value
measurements. Those disclosures are effective for fiscal years after December
15, 2010 and for interim periods within those fiscal years. Early adoption is
permitted. The Company has adopted the required portions of ASU 2009-16
effective January 1, 2010 and has included the required
disclosures.





In April
2010, FASB issued ASU 2010-18, Receivables (Topic 310): Effect of a
Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a
Single Asset,codifies the consensus reached in EITF Issue No. 09-I,
“Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted
for as a Single Asset.” The amendments to the Codification provide that
modifications of loans that are accounted for within a pool under Subtopic
310-30 do not result in the removal of those loans from the pool even if the
modification of those loans would otherwise be considered a troubled debt
restructuring. An entity will continue to be required to consider whether the
pool of assets in which the loan is included is impaired if expected cash flows
for the pool change. ASU 2010-18 does not affect the accounting for loans under
the scope of Subtopic 310-30 that are not accounted for within pools. Loans
accounted for individually under Subtopic 310-30 continue to be subject to the
troubled debt restructuring accounting provisions within Subtopic
310-40.


ASU
2010-18 is effective prospectively for modifications of loans accounted for
within pools under Subtopic 310-30 occurring in the first interim or annual
period ending on or after July 15, 2010. Early application is permitted. Upon
initial adoption of ASU 2010-18, an entity may make a one-time election to
terminate accounting for loans as a pool under Subtopic 310-30. This election
may be applied on a pool-by-pool basis and does not preclude an entity from
applying pool accounting to subsequent acquisitions of loans with credit
deterioration. The adoption of ASU 2010-18 is not expected to have a material
impact on the Company’s financial position or results of
operations.





In July
2010, FASB issued ASU 2010-20, Receivables (Topic 310): Disclosures
about the Credit Quality of Financing Receivables and the Allowance for Credit
Losses, which is intended to help investors assess the credit risk of a
company’s receivables portfolio and the adequacy of its allowance for credit
losses held against the portfolios by expanding credit risk
disclosures. This ASU requires more information about the credit quality of
financing receivables in the disclosures to financial statements, such as aging
information and credit quality indicators. Both new and existing disclosures
must be disaggregated by portfolio segment or class. The disaggregation of
information will be based on how a company develops its allowance for credit
losses and how it manages its credit exposure. The amendments in this Update
apply to all entities with financing receivables. Financing receivables include
loans and trade accounts receivable. However, short-term trade accounts
receivable, receivables measured at fair value or lower of cost or fair value,
and debt securities are exempt from these disclosure amendments. The
effective date of ASU 2010-20 differs for public and nonpublic companies. For
QNB, the amendments that require disclosures as of the end of a reporting period
are effective for periods ending on or after December 15, 2010. The amendments
that require disclosures about activity that occurs during a reporting period
are effective for periods beginning on or after December 15, 2010.





3.
STOCK-BASED COMPENSATION AND SHAREHOLDERS’ EQUITY





QNB
sponsors stock-based compensation plans, administered by a committee, under
which both qualified and non-qualified stock options may be granted periodically
to certain employees. Compensation cost has been measured using the fair value
of an award on the grant date and is recognized over the service period, which
is usually the vesting period.


- 8
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





3.
STOCK-BASED COMPENSATION AND SHAREHOLDERS’ EQUITY (Continued)





Stock-based
compensation expense was approximately $11,000 and $12,000 for the three months
ended September 30, 2010 and 2009, respectively, and $36,000 and $41,000 for the
nine months ended September 30, 2010 and 2009, respectively. As of September 30,
2010, there was approximately $64,000 of unrecognized compensation cost related
to unvested share-based compensation awards granted that is expected to be
recognized over the next 35 months.





Options
are granted to certain employees at prices equal to the market value of the
stock on the date the options are granted. The 1998 Plan authorizes the issuance
of 220,500 shares. The time period during which any option is exercisable under
the Plan is determined by the committee but shall not commence before the
expiration of six months after the date of grant or continue beyond the
expiration of ten years after the date the option is awarded. The granted
options vest ratably over a three-year period. As of September 30, 2010, there
were 225,058 options granted, 14,844 options forfeited, 81,050 options exercised
and 129,164 options outstanding under this Plan. The 1998 Plan expired on March
10, 2008, therefore no further options can be granted under this
Plan.





The 2005
Plan authorizes the issuance of 200,000 shares. The terms of the 2005 Plan are
identical to the 1998 Plan, except options expire five years after the grant
date. As of September 30, 2010, there were 83,700 options granted, 16,550
options forfeited and 67,150 options outstanding under this Plan. The 2005 Plan
expires March 15, 2015.





The fair
value of each option is amortized into compensation expense on a straight-line
basis between the grant date for the option and each vesting date. QNB estimated
the fair value of stock options on the date of the grant using the Black-Scholes
option pricing model. The model requires the use of numerous assumptions, many
of which are highly subjective in nature.





The
following assumptions were used in the option pricing model in determining the
fair value of options granted during the nine months ended September
30:





Options
      granted
                  
                  2010
                  
                  
                  2009Risk-free
      interest rate
                  
                  
                  2.19
                  %
                  
                  
                  1.48
                  %Dividend
      yield
                  
                  
                  5.26
                  
                  
                  
                  4.80Volatility
                  
                  
                  27.77
                  
                  
                  
                  25.04Expected
      life (years)
                  
                  
                  5.00
                  
                  
                  
                  5.00





The
risk-free interest rate was selected based upon yields of U.S. Treasury issues
with a term equal to the expected life of the option being valued. Historical
information was the primary basis for the selection of the expected dividend
yield, expected volatility and expected lives of the options.





The fair
market value of options granted in 2010 and 2009 was $2.55 and $2.17,
respectively.


- 9
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





3.
STOCK-BASED COMPENSATION AND SHAREHOLDERS’ EQUITY (Continued)





Stock
option activity during the nine months ended September 30, 2010 is as
follows:


Number
                            of Options
                          
                          
                          Weighted
                            Average
                            Exercise Price
                          
                          
                          Weighted
                            Average
                            Remaining
                            Contractual
                            Term (in yrs.)
                          
                          
                          Aggregate
                            Intrinsic
                            ValueOutstanding
      at January 1, 2010
                          
                          
                          200,802
                          
                          
                          $
                          21.36Exercised
                          
                          
                          (5,292
                          )
                          
                          
                          13.09Forfeited
                          
                          
                          (19,196
                          )
                          
                          
                          18.82Granted
                          
                          
                          20,000
                          
                          
                          
                          17.63Outstanding
      at September 30, 2010
                          
                          
                          196,314
                          
                          
                          $
                          21.45
                          
                          
                          
                          2.2
                          
                          
                          $
                          353Exercisable
      at September 30, 2010
                          
                          
                          152,714
                          
                          
                          $
                          22.32
                          
                          
                          
                          1.9
                          
                          
                          $
                          273





4. SHARE REPURCHASE
PLAN





The Board
of Directors has authorized the repurchase of up to 100,000 shares of its common
stock in open market or privately negotiated transactions. The repurchase
authorization does not bear a termination date. There were no shares repurchased
during the nine months ended September 30, 2010. As of September 30, 2010,
57,883 shares were repurchased under this authorization at an average price of
$16.97 and a total cost of $982,000.





5.
EARNINGS PER SHARE





The
following sets forth the computation of basic and diluted earnings per
share:


For the Three Months
                        
                        
                        For the Nine MonthsEnded September 30,
                        
                        
                        Ended September 30,2010
                        
                        
                        2009
                        
                        
                        2010
                        
                        
                        2009Numerator
      for basic and diluted earnings per share - net income
                        
                        $
                        1,618
                        
                        
                        $
                        671
                        
                        
                        $
                        5,407
                        
                        
                        $
                        2,992Denominator
      for basic earnings per share - weighted average shares
      outstanding
                        
                        
                        3,108,535
                        
                        
                        
                        3,089,382
                        
                        
                        
                        3,101,025
                        
                        
                        
                        3,095,889Effect
      of dilutive securities - employee stock options
                        
                        
                        14,727
                        
                        
                        
                        8,040
                        
                        
                        
                        11,714
                        
                        
                        
                        9,636Denominator
      for diluted earnings per share - adjusted weighted average shares
      outstanding
                        
                        
                        3,123,262
                        
                        
                        
                        3,097,422
                        
                        
                        
                        3,112,739
                        
                        
                        
                        3,105,525Earnings
      per share-basic
                        
                        $
                        0.52
                        
                        
                        $
                        0.22
                        
                        
                        $
                        1.74
                        
                        
                        $
                        0.97Earnings
      per share-diluted
                        
                        $
                        0.52
                        
                        
                        $
                        0.22
                        
                        
                        $
                        1.74
                        
                        
                        $
                        0.96





There
were 113,700 and 128,100 stock options that were anti-dilutive for the three-
and nine-month periods ended September 30, 2010, respectively. There were
138,800 stock options that were anti-dilutive for each of the three- and
nine-month periods ended September 30, 2009. These stock options were not
included in the above calculation.


- 10
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





6.
COMPREHENSIVE INCOME





For QNB,
the sole component of other comprehensive income is the unrealized holding gains
and losses on available-for-sale investment securities.





The
following shows the components and activity of comprehensive income during the
periods ended September 30, 2010 and 2009:


Three Months Ended
                              
                              September 30,
                                2010
                              
                              
                              September 30,
                                2009Unrealized
      holding gains arising during the period
                              
                              $
                              789
                              
                              
                              $
                              4,932Unrealized
      losses related to factors other than credit arising during the
      period
                              
                              
                              -
                              
                              
                              
                              (1,526
                              )Reclassification
      adjustment for gains included in net income
                              
                              
                              (4
                              )
                              
                              
                              (103
                              )Reclassification
      adjustment for OTTI losses included in net income
                              
                              
                              51
                              
                              
                              
                              2,279Net
      unrealized gains
                              
                              
                              836
                              
                              
                              
                              5,582Tax
      effect
                              
                              
                              (284
                              )
                              
                              
                              (1,898
                              )Other
      comprehensive income, net of tax
                              
                              
                              552
                              
                              
                              
                              3,684Net
      income
                              
                              
                              1,618
                              
                              
                              
                              671Total
      comprehensive income
                              
                              $
                              2,170
                              
                              
                              $
                              4,355





Nine Months Ended
                              
                              September 30,
                                2010
                              
                              
                              September 30,
                                2009Unrealized
      holding gains arising during the period
                              
                              $
                              4,088
                              
                              
                              $
                              4,412Unrealized
      losses related to factors other than credit arising during the
      period
                              
                              
                              (27
                              )
                              
                              
                              (1,574
                              )Reclassification
      adjustment for gains included in net income
                              
                              
                              (299
                              )
                              
                              
                              (346
                              )Reclassification
      adjustment for OTTI losses included in net income
                              
                              
                              304
                              
                              
                              
                              2,850Net
      unrealized gains
                              
                              
                              4,066
                              
                              
                              
                              5,342Tax
      effect
                              
                              
                              (1,382
                              )
                              
                              
                              (1,817
                              )Other
      comprehensive income, net of tax
                              
                              
                              2,684
                              
                              
                              
                              3,525Net
      income
                              
                              
                              5,407
                              
                              
                              
                              2,992Total
      comprehensive income
                              
                              $
                              8,091
                              
                              
                              $
                              6,517




- 11
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





7.
INVESTMENT SECURITIES





The
amortized cost and estimated fair values of investment securities
available-for-sale at September 30, 2010 and December 31, 2009 were as
follows:


Available-for-SaleSeptember
      30, 2010Gross
                      
                      
                      GrossAggregate
                      
                      
                      unrealized
                      
                      
                      unrealized holding lossesfair
                      
                      
                      holding
                      
                      
                      Non-credit
                      
                      
                      
                      
                      
                      Amortizedvalue
                      
                      
                      gains
                      
                      
                      OTTI
                      
                      
                      Other
                      
                      
                      costU.S.
      Treasury
                      
                      $
                      4,515
                      
                      
                      $
                      11
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      $
                      4,504U.S.
      Government agencies
                      
                      
                      63,074
                      
                      
                      
                      501
                      
                      
                      
                      -
                      
                      
                      $
                      19
                      
                      
                      
                      62,592State
      and municipal securities
                      
                      
                      61,333
                      
                      
                      
                      2,565
                      
                      
                      
                      -
                      
                      
                      
                      39
                      
                      
                      
                      58,807U.S.
      Government agencies and sponsored enterprises (GSEs) -
      residentialMortgage-backed
      securities
                      
                      
                      72,976
                      
                      
                      
                      2,846
                      
                      
                      
                      -
                      
                      
                      
                      14
                      
                      
                      
                      70,144Collateralized
      mortgage obligations (CMOs)
                      
                      
                      71,760
                      
                      
                      
                      2,448
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      69,312Other
      debt securities
                      
                      
                      2,193
                      
                      
                      
                      79
                      
                      
                      $
                      1,451
                      
                      
                      
                      524
                      
                      
                      
                      4,089Equity
      securities
                      
                      
                      3,400
                      
                      
                      
                      350
                      
                      
                      
                      -
                      
                      
                      
                      76
                      
                      
                      
                      3,126Total
      investment securities available-for-sale
                      
                      $
                      279,251
                      
                      
                      $
                      8,800
                      
                      
                      $
                      1,451
                      
                      
                      $
                      672
                      
                      
                      $
                      272,574





December
      31, 2009Gross
                      
                      
                      GrossAggregate
                      
                      
                      unrealized
                      
                      
                      unrealized holding lossesfair
                      
                      
                      holding
                      
                      
                      Non-credit
                      
                      
                      
                      
                      
                      Amortizedvalue
                      
                      
                      gains
                      
                      
                      OTTI
                      
                      
                      Other
                      
                      
                      costU.S.
      Treasury
                      
                      $
                      5,013
                      
                      
                      $
                      2
                      
                      
                      
                      -
                      
                      
                      $
                      1
                      
                      
                      $
                      5,012U.S.
      Government agencies
                      
                      
                      69,731
                      
                      
                      
                      261
                      
                      
                      
                      -
                      
                      
                      
                      316
                      
                      
                      
                      69,786State
      and municipal securities
                      
                      
                      54,160
                      
                      
                      
                      1,287
                      
                      
                      
                      -
                      
                      
                      
                      59
                      
                      
                      
                      52,932U.S.
      Government agencies and sponsored enterprises (GSEs) -
      residential
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      -Mortgage-backed
      securities
                      
                      
                      61,649
                      
                      
                      
                      2,215
                      
                      
                      
                      -
                      
                      
                      
                      69
                      
                      
                      
                      59,503Collateralized
      mortgage obligations (CMOs)
                      
                      
                      61,317
                      
                      
                      
                      1,787
                      
                      
                      
                      -
                      
                      
                      
                      60
                      
                      
                      
                      59,590Other
      debt securities
                      
                      
                      1,533
                      
                      
                      
                      78
                      
                      
                      $
                      2,410
                      
                      
                      
                      655
                      
                      
                      
                      4,520Equity
      securities
                      
                      
                      3,459
                      
                      
                      
                      565
                      
                      
                      
                      -
                      
                      
                      
                      14
                      
                      
                      
                      2,908Total
      investment securities available-for-sale
                      
                      $
                      256,862
                      
                      
                      $
                      6,195
                      
                      
                      $
                      2,410
                      
                      
                      $
                      1,174
                      
                      
                      $
                      254,251





The
amortized cost and estimated fair value of securities available-for-sale by
contractual maturity at September 30, 2010 are shown in the following table.
Expected maturities will differ from contractual maturities because borrowers
may have the right to call or prepay obligations with or without call or
prepayment penalties. Securities are assigned to categories based on contractual
maturity except for mortgage-backed securities and CMOs which are based on the
estimated average life of these securities.


Aggregate
                        
                        
                        Amortizedfair value
                        
                        
                        costDue
      in one year or less
                        
                        $
                        12,558
                        
                        
                        $
                        12,436Due
      after one year through five years
                        
                        
                        172,960
                        
                        
                        
                        167,346Due
      after five years through ten years
                        
                        
                        49,699
                        
                        
                        
                        48,714Due
      after ten years
                        
                        
                        40,634
                        
                        
                        
                        40,952Equity
      securities
                        
                        
                        3,400
                        
                        
                        
                        3,126Total
      investment securities available-for-sale
                        
                        $
                        279,251
                        
                        
                        $
                        272,574




- 12
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





7.
INVESTMENT SECURITIES (Continued)





Proceeds
from sales of investment securities available-for-sale were $3,476,000 and
$7,161,000 for the nine months ended September 30, 2010 and 2009,
respectively.





At
September 30, 2010 and December 31, 2009, investment securities
available-for-sale totaling $139,674,000 and $133,136,000, respectively, were
pledged as collateral for repurchase agreements and deposits of public
funds.





The
following table presents information related to the Company’s gains and losses
on the sales of equity and debt securities, and losses recognized for the
other-than-temporary impairment of these investments. Gains and losses on
available-for-sale securities are computed on the specific identification method
and included in non-interest income. Gross realized losses on equity and debt
securities are net of other-than-temporary impairment charges:


Nine months ended September 30, 2010:Other-than-Gross
                        
                        
                        Gross
                        
                        
                        temporaryRealized
                        
                        
                        Realized
                        
                        
                        impairment
                        
                        
                        Net gainsGains
                        
                        
                        Losses
                        
                        
                        losses
                        
                        
                        (losses)Equity
      securities
                        
                        $
                        287
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        287Debt
      securities
                        
                        
                        14
                        
                        
                        
                        (2
                        )
                        
                        
                        (277
                        )
                        
                        
                        (265
                        )Total
                        
                        $
                        301
                        
                        
                        $
                        (2
                        )
                        
                        $
                        (277
                        )
                        
                        $
                        22





Nine
      months ended September 30, 2009:Other-than-Gross
                        
                        
                        Gross
                        
                        
                        temporaryRealized
                        
                        
                        Realized
                        
                        
                        impairment
                        
                        
                        Net
      gainsGains
                        
                        
                        Losses
                        
                        
                        losses
                        
                        
                        (losses)Equity
      securities
                        
                        $
                        211
                        
                        
                        $
                        (1
                        )
                        
                        $
                        (515
                        )
                        
                        $
                        (305
                        )Debt
      securities
                        
                        
                        136
                        
                        
                        
                        -
                        
                        
                        
                        (761
                        )
                        
                        
                        (625
                        )Total
                        
                        $
                        347
                        
                        
                        $
                        (1
                        )
                        
                        $
                        (1,276
                        )
                        
                        $
                        (930
                        )





The tax
expense applicable to the net realized gains for the nine months ended September
30, 2010 was $7,000. The tax benefit applicable to the net realized losses for
the nine months ended September 30, 2009 amounted to $316,000.





All
other-than-temporary impairment (OTTI) writedowns on equity securities were on
marketable equity securities held by the holding company. All OTTI writedowns on
debt securities were on pooled trust preferred securities, which are included in
the other debt securities category, held at the Bank.





QNB
recognizes OTTI for debt securities classified as available-for-sale in
accordance with FASB ASC 320, Investments – Debt and Equity
Securities, which requires that we assess whether we intend to sell or it
is more likely than not that the Company will be required to sell a security
before recovery of its amortized cost basis less any current-period credit
losses. For debt securities that are considered other-than-temporarily impaired
and that we do not intend to sell and will not be required to sell prior to
recovery of our amortized cost basis, the amount of the impairment is separated
into the amount that is credit related (credit loss component) and the amount
due to all other factors. The credit loss component is recognized in earnings
and is the difference between the security’s amortized cost basis and the
present value of its expected future cash flows discounted at the security’s
effective yield. The remaining difference between the security’s fair value and
the present value of future expected cash flows is due to factors that are not
credit related and, therefore, is not required to be recognized as a loss in the
income statement, but is recognized in other comprehensive income. For equity
securities, once a decline in value is determined to be other-than-temporary,
the value of the equity security is reduced to fair
value and a corresponding charge to earnings is recognized. QNB believes that we
will fully collect the carrying value of securities on which we have recorded a
non-credit related impairment in other comprehensive income.


- 13
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





7.
INVESTMENT SECURITIES (Continued)





The table
below presents a rollforward of the credit loss component recognized in
earnings. The credit loss component of the amortized cost represents the
difference between the present value of expected future cash flows and the
amortized cost basis of the security prior to considering credit losses. The
beginning balance represents the credit loss component for debt securities for
which OTTI occurred prior to January 1, 2010. OTTI recognized in earnings in
2010 for credit-impaired debt securities is presented as additions in two
components based upon whether the current period is the first time the debt
security was credit-impaired (initial credit impairment) or is not the first
time the debt security was credit-impaired (subsequent credit impairments). If
we sell, intend to sell or believe we will be required to sell previously
credit-impaired debt securities, an OTTI write-down is recognized in earnings
equal to the entire difference between the security’s amortized cost basis and
its fair value. The following table presents a summary of the cumulative credit
related other-than-temporary impairment charges recognized as components of
earnings for debt securities still held by QNB:


Three Months Ended
                        September 30,
                      
                      
                      Nine Months Ended
                        September 30,2010
                      
                      
                      2009
                      
                      
                      2010
                      
                      
                      2009Balance,
      beginning of period
                      
                      $
                      1,228
                      
                      
                      $
                      8
                      
                      
                      $
                      1,002
                      
                      
                      $
                      -Additions:Initial
      credit impairments
                      
                      
                      -
                      
                      
                      
                      753
                      
                      
                      
                      -
                      
                      
                      
                      761Subsequent
      credit impairments
                      
                      
                      51
                      
                      
                      
                      -
                      
                      
                      
                      277
                      
                      
                      
                      -Balance,
      end of period
                      
                      $
                      1,279
                      
                      
                      $
                      761
                      
                      
                      $
                      1,279
                      
                      
                      $
                      761





The
amortized cost and estimated fair values of investment securities
held-to-maturity at September 30, 2010 and December 31, 2009 were as
follows:


Held-To-Maturity


September 30, 2010
                                    
                                    
                                    December 31, 2009Gross
                                    
                                    
                                    Gross
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    Gross
                                    
                                    
                                    Grossunrealized
                                    
                                    
                                    unrealized
                                    
                                    
                                    Aggregate
                                    
                                    
                                    
                                    
                                    
                                    unrealized
                                    
                                    
                                    unrealized
                                    
                                    
                                    AggregateAmortized
                                    
                                    
                                    holding
                                    
                                    
                                    holding
                                    
                                    
                                    fair
                                    
                                    
                                    Amortized
                                    
                                    
                                    holding
                                    
                                    
                                    holding
                                    
                                    
                                    faircost
                                    
                                    
                                    gains
                                    
                                    
                                    losses
                                    
                                    
                                    value
                                    
                                    
                                    cost
                                    
                                    
                                    gains
                                    
                                    
                                    losses
                                    
                                    
                                    valueState
      and municipal securities
                                    
                                    $
                                    2,847
                                    
                                    
                                    $
                                    97
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    2,944
                                    
                                    
                                    $
                                    3,347
                                    
                                    
                                    $
                                    124
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    3,471





The
amortized cost and estimated fair value of securities held-to-maturity by
contractual maturity at September 30, 2010 are shown in the following table.
Expected maturities will differ from contractual maturities because borrowers
may have the right to call or prepay obligations with or without call or
prepayment penalties.


Aggregate
                        
                        
                        Amortizedfair value
                        
                        
                        costDue
      in one year or less
                        
                        
                        -
                        
                        
                        
                        -Due
      after one year through five years
                        
                        
                        -
                        
                        
                        
                        -Due
      after five years through ten years
                        
                        $
                        2,944
                        
                        
                        $
                        2,847Due
      after ten years
                        
                        
                        -
                        
                        
                        
                        -Total
      investment securities held-to-maturity
                        
                        $
                        2,944
                        
                        
                        $
                        2,847




- 14
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





7.
INVESTMENT SECURITIES (Continued)





There
were no sales of investment securities classified as held-to-maturity during the
nine months ended September 30, 2010 or 2009.





The
following table indicates the length of time individual securities have been in
a continuous unrealized loss position at September 30, 2010 and December 31,
2009:


September 30, 2010


Less than 12 months
                                          
                                          
                                          12 months or longer
                                          
                                          
                                          TotalNo. of
                                          
                                          
                                          Fair
                                          
                                          
                                          Unrealized
                                          
                                          
                                          Fair
                                          
                                          
                                          Unrealized
                                          
                                          
                                          Fair
                                          
                                          
                                          Unrealizedsecurities
                                          
                                          
                                          value
                                          
                                          
                                          losses
                                          
                                          
                                          value
                                          
                                          
                                          losses
                                          
                                          
                                          value
                                          
                                          
                                          lossesU.S.
      Government agencies
                                          
                                          
                                          5
                                          
                                          
                                          $
                                          10,953
                                          
                                          
                                          $
                                          19
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -
                                          
                                          
                                          $
                                          10,953
                                          
                                          
                                          $
                                          19State
      and municipal securities
                                          
                                          
                                          5
                                          
                                          
                                          
                                          1,493
                                          
                                          
                                          
                                          32
                                          
                                          
                                          $
                                          493
                                          
                                          
                                          $
                                          7
                                          
                                          
                                          
                                          1,986
                                          
                                          
                                          
                                          39Mortgage-backed
      securities
                                          
                                          
                                          6
                                          
                                          
                                          
                                          8,231
                                          
                                          
                                          
                                          14
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          8,231
                                          
                                          
                                          
                                          14Other
      debt securities
                                          
                                          
                                          7
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          1,665
                                          
                                          
                                          
                                          1,975
                                          
                                          
                                          
                                          1,665
                                          
                                          
                                          
                                          1,975Equity
      securities
                                          
                                          
                                          9
                                          
                                          
                                          
                                          1,047
                                          
                                          
                                          
                                          76
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          1,047
                                          
                                          
                                          
                                          76Total
                                          
                                          
                                          32
                                          
                                          
                                          $
                                          21,724
                                          
                                          
                                          $
                                          141
                                          
                                          
                                          $
                                          2,158
                                          
                                          
                                          $
                                          1,982
                                          
                                          
                                          $
                                          23,882
                                          
                                          
                                          $
                                          2,123




December 31, 2009


Less than 12 months
                                        
                                        
                                        12 months or longer
                                        
                                        
                                        TotalNo. of
                                        
                                        
                                        Fair
                                        
                                        
                                        Unrealized
                                        
                                        
                                        Fair
                                        
                                        
                                        Unrealized
                                        
                                        
                                        Fair
                                        
                                        
                                        Unrealizedsecurities
                                        
                                        
                                        value
                                        
                                        
                                        losses
                                        
                                        
                                        value
                                        
                                        
                                        losses
                                        
                                        
                                        value
                                        
                                        
                                        lossesU.S.
      Treasuries
                                        
                                        
                                        3
                                        
                                        
                                        $
                                        2,509
                                        
                                        
                                        $
                                        1
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        $
                                        2,509
                                        
                                        
                                        $
                                        1U.S.
      Government agencies
                                        
                                        
                                        24
                                        
                                        
                                        
                                        28,675
                                        
                                        
                                        
                                        316
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        28,675
                                        
                                        
                                        
                                        316State
      and municipal securities
                                        
                                        
                                        17
                                        
                                        
                                        
                                        6,309
                                        
                                        
                                        
                                        45
                                        
                                        
                                        $
                                        659
                                        
                                        
                                        $
                                        14
                                        
                                        
                                        
                                        6,968
                                        
                                        
                                        
                                        59Mortgage-backed
      securities
                                        
                                        
                                        5
                                        
                                        
                                        
                                        6,934
                                        
                                        
                                        
                                        69
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        6,934
                                        
                                        
                                        
                                        69Collateralized
      mortgage obligations (CMOs)
                                        
                                        
                                        6
                                        
                                        
                                        
                                        6,929
                                        
                                        
                                        
                                        60
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        6,929
                                        
                                        
                                        
                                        60Other
      debt securities
                                        
                                        
                                        8
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        1,008
                                        
                                        
                                        
                                        3,065
                                        
                                        
                                        
                                        1,008
                                        
                                        
                                        
                                        3,065Equity
      securities
                                        
                                        
                                        4
                                        
                                        
                                        
                                        392
                                        
                                        
                                        
                                        4
                                        
                                        
                                        
                                        137
                                        
                                        
                                        
                                        10
                                        
                                        
                                        
                                        529
                                        
                                        
                                        
                                        14Total
                                        
                                        
                                        67
                                        
                                        
                                        $
                                        51,748
                                        
                                        
                                        $
                                        495
                                        
                                        
                                        $
                                        1,804
                                        
                                        
                                        $
                                        3,089
                                        
                                        
                                        $
                                        53,552
                                        
                                        
                                        $
                                        3,584





Management
evaluates debt securities, which are comprised of U.S. Government agencies,
state and municipalities, mortgage-backed securities, CMOs and other issuers,
for other-than-temporary impairment and considers the current economic
conditions, the length of time and the extent to which the fair value has been
less than cost, interest rates and the bond rating of each security. The
unrealized losses at September 30, 2010 in U.S. Government agencies, state and
municipal securities and mortgage-backed securities are primarily the result of
interest rate fluctuations. If held to maturity, these bonds will mature at par,
and QNB will not realize a loss. The Company has the intent to hold the
securities and does not believe it will be required to sell the securities
before recovery occurs.





The
Company’s investment in marketable equity securities primarily consists of
investments in large cap stock companies. These equity securities are analyzed
for impairment on an ongoing basis. Management believes these equity securities
will recover in the foreseeable future. QNB evaluated the near-term prospects of
the issuers in relation to the severity and duration of the impairment. Based on
that evaluation and the Company’s ability and intent to hold those securities
for a reasonable period of time sufficient for a forecasted recovery of fair
value, the Company does not consider these equity securities to be
other-than-temporarily impaired.


- 15
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





7.
INVESTMENT SECURITIES (Continued)





All of
the securities in the other debt securities category with unrealized losses
greater than twelve months as of September 30, 2010 are pooled trust preferred
security issues. QNB holds eight of these securities with an amortized cost of
$3,640,000 and a fair value of $1,665,000. All of the trust preferred securities
are available-for-sale securities and are carried at fair value. The following
table provides additional information related to pooled trust preferred
securities as of September 30, 2010:


Deal
                                                  
                                                  Class
                                                  
                                                  Book
                                                    value
                                                  
                                                  
                                                  Fair
                                                    value
                                                  
                                                  
                                                  Unreal-
                                                    ized loss
                                                  
                                                  
                                                  Realized
                                                    OTTI
                                                    Credit
                                                    Loss
                                                    (YTD
                                                    2010)
                                                  
                                                  
                                                  Moody's
                                                    /Fitch
                                                    ratings
                                                  
                                                  
                                                  Current
                                                    number
                                                    of banks
                                                  
                                                  
                                                  Current
                                                    number of
                                                    insurance
                                                    companies
                                                  
                                                  
                                                  Actual
                                                    deferrals and
                                                    defaults as a%
                                                    of total
                                                    collateral
                                                  
                                                  
                                                  Total
                                                    performing
                                                    collateral as a
                                                    % of
                                                    outstanding
                                                    bondsPreTSL
      IV
                                                  
                                                  Mezzanine*
                                                  
                                                  $
                                                  243
                                                  
                                                  
                                                  $
                                                  168
                                                  
                                                  
                                                  $
                                                  (75
                                                  )
                                                  
                                                  $
                                                  -
                                                  
                                                  
                                                  Ca/CCC
                                                  
                                                  
                                                  
                                                  5
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  27.1
                                                  %
                                                  
                                                  
                                                  123.8
                                                  %PreTSL
      V
                                                  
                                                  Mezzanine*
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  (71
                                                  )
                                                  
                                                  Ba3/D
                                                  
                                                  
                                                  
                                                  1
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  100.0
                                                  %
                                                  
                                                  
                                                  11.4
                                                  %PreTSL
      VI
                                                  
                                                  Mezzanine*
                                                  
                                                  
                                                  121
                                                  
                                                  
                                                  
                                                  113
                                                  
                                                  
                                                  
                                                  (8
                                                  )
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  Ca/D
                                                  
                                                  
                                                  
                                                  5
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  81.0
                                                  %
                                                  
                                                  
                                                  50.2
                                                  %PreTSL
      XVII
                                                  
                                                  Mezzanine
                                                  
                                                  
                                                  752
                                                  
                                                  
                                                  
                                                  222
                                                  
                                                  
                                                  
                                                  (530
                                                  )
                                                  
                                                  
                                                  (197
                                                  )
                                                  
                                                  Ca/C
                                                  
                                                  
                                                  
                                                  46
                                                  
                                                  
                                                  
                                                  6
                                                  
                                                  
                                                  
                                                  35.7
                                                  %
                                                  
                                                  
                                                  71.8
                                                  %PreTSL
      XIX
                                                  
                                                  Mezzanine
                                                  
                                                  
                                                  988
                                                  
                                                  
                                                  
                                                  463
                                                  
                                                  
                                                  
                                                  (525
                                                  )
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  C/C
                                                  
                                                  
                                                  
                                                  51
                                                  
                                                  
                                                  
                                                  14
                                                  
                                                  
                                                  
                                                  24.6
                                                  %
                                                  
                                                  
                                                  83.9
                                                  %PreTSL
      XXV
                                                  
                                                  Mezzanine
                                                  
                                                  
                                                  766
                                                  
                                                  
                                                  
                                                  227
                                                  
                                                  
                                                  
                                                  (539
                                                  )
                                                  
                                                  
                                                  (9
                                                  )
                                                  
                                                  
                                                  C/C
                                                  
                                                  
                                                  
                                                  60
                                                  
                                                  
                                                  
                                                  8
                                                  
                                                  
                                                  
                                                  32.6
                                                  %
                                                  
                                                  
                                                  76.6
                                                  %PreTSL
      XXVI
                                                  
                                                  Mezzanine
                                                  
                                                  
                                                  469
                                                  
                                                  
                                                  
                                                  207
                                                  
                                                  
                                                  
                                                  (262
                                                  )
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  C/C
                                                  
                                                  
                                                  
                                                  52
                                                  
                                                  
                                                  
                                                  10
                                                  
                                                  
                                                  
                                                  30.4
                                                  %
                                                  
                                                  
                                                  79.2
                                                  %PreTSL
      XXVI
                                                  
                                                  Mezzanine
                                                  
                                                  
                                                  301
                                                  
                                                  
                                                  
                                                  265
                                                  
                                                  
                                                  
                                                  (36
                                                  )
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  C/C
                                                  
                                                  
                                                  
                                                  52
                                                  
                                                  
                                                  
                                                  10
                                                  
                                                  
                                                  
                                                  30.4
                                                  %
                                                  
                                                  
                                                  79.2
                                                  %$
                                                  3,640
                                                  
                                                  
                                                  $
                                                  1,665
                                                  
                                                  
                                                  $
                                                  (1,975
                                                  )
                                                  
                                                  $
                                                  (277
                                                  )


Mezzanine*
- only class of bonds still outstanding (represents the senior-most obligation
of the trust)





The
market for these securities at September 30, 2010 is not active and markets for
similar securities are also not active. The inactivity was evidenced first by a
significant widening of the bid-ask spread in the brokered markets in which
pooled trust preferred securities trade and then by a significant decrease in
the volume of trades relative to historical levels. The new issue market is also
inactive and the market values for these securities (and any securities other
than those issued or guaranteed by U.S. Government agencies) are depressed
relative to historical levels. In today’s market, a low market price for a
particular bond may only provide evidence of a recent widening of corporate
spreads in general versus being an indicator of credit problems with a
particular issuer. Lack of liquidity in the market for trust preferred
collateralized debt obligations, credit rating downgrades and market
uncertainties related to the financial industry are factors contributing to the
impairment of these securities. Although these securities are classified as
available-for-sale, the Company has the intent to hold the securities and does
not believe it will be required to sell the securities before recovery occurs.
As illustrated in the table above, these securities are comprised mainly of
securities issued by banks, and to a lesser degree, insurance companies. QNB
owns the mezzanine tranches of these securities.





On a
quarterly basis we evaluate our debt securities for OTTI, which involves the use
of a third-party valuation firm to assist management with the valuation. When
evaluating these investments a credit related portion and a non-credit related
portion of OTTI are determined. The credit related portion is recognized in
earnings and represents the expected shortfall in future cash flows. The
non-credit related portion is recognized in other comprehensive income and
represents the difference between the fair value adjustment for the security and
the amount of credit related impairment. For the three and nine months ended
September 30, 2010, $51,000 and $277,000, respectively, in other-than-temporary
impairment charges representing credit impairment were recognized on our pooled
trust preferred security issues. A discounted cash flow analysis provides the
best estimate of credit related OTTI for these securities. Additional
information related to this analysis follows:


- 16
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





7.
INVESTMENT SECURITIES (Continued)





All of
the pooled trust preferred collateralized debt obligations held by QNB are rated
lower than AA and are measured for OTTI within the scope of ASC 325 (formerly
known as EITF 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 FinancialAssets, and Amendments to the Impairment
Guidance of EITF Issue No. 99-20(formerly known as EITF
99-20-1). QNB performs a discounted cash flow analysis on all of its
impaired debt securities to determine if the amortized cost basis of an impaired
security will be recovered. In determining whether a credit loss exists, QNB
uses its best estimate of the present value of cash flows expected to be
collected from the debt security and discounts them at the current accretable
yield. The discounted cash flow analysis is considered to be the primary
evidence when determining whether credit related other-than-temporary impairment
exists.





Results
of a discounted cash flow test are significantly affected by other variables
such as the estimate of future cash flows (including prepayments), credit
worthiness of the underlying banks and insurance companies and determination of
probability and severity of default of the underlying collateral. The following
provides additional information for each of these variables:


·
            Estimate
      of Future Cash Flows – Cash flows are constructed in an INTEX desktop
      valuation model. INTEX is a proprietary cash flow model recognized as the
      industry standard for analyzing all types of structured debt products. It
      includes each deal’s structural features updated with trustee information,
      including asset-by-asset detail, as it becomes available. The modeled cash
      flows are then used to determine if all the scheduled principal and
      interest payments of the investments will be returned. For purposes of the
      cash flow analysis, relatively modest rates of prepayment were forecasted
      (ranging from 0-2%). In addition to the base prepayment assumption, due to
      the recent enactment of the Dodd-Frank financial legislation additional
      prepayment analysis was performed. First, all fixed rate trust preferred
      securities issued by banks with more than $15 billion in total assets at
      December 31, 2009 were identified. Next the holding companies’ approximate
      cost of long-term funding given their rating and marketplace interest
      rates were estimated. The following assumption was made; any holding
      company that could refinance for a cost savings of more than 2% will
      refinance and will do so on January 1, 2013, or January 1, 2015 for bank
      holding company subsidiaries of foreign banking organizations that have
      relied on Supervision and Regulation Letter
  SR-01-1.


·
            Credit
      Analysis – A quarterly credit evaluation is performed for the companies
      comprising the collateral across the various pooled trust preferred
      securities. This credit evaluation considers all available evidence and
      focuses on capitalization, asset quality, profitability, liquidity, stock
      price performance, whether the institution has received TARP funding and
      whether the institution has shown the ability to raise
      capital.


·
            Probability
      of Default – A near-term probability of default is determined for each
      issuer based on its financial condition and is used to calculate the
      expected impact of future deferrals and defaults on the expected cash
      flows. Each issuer in the collateral pool is assigned a near-term
      probability of default based on individual performance and financial
      characteristics. Various studies suggest that the rate of bank failures
      between 1934 and 2008 were approximately 0.36%. Thus, in addition to the
      specific bank default assumptions, future defaults on the individual banks
      in the analysis are assumed at 1% for 2011 (approximately three times
      historical norms), 0.75% for 2012 (two times historical levels) and for
      2013 and beyond the rate used is calculated based upon individual issuers
      estimated CAMEL rating as projected by VERIBANC®.
      Banks in the pool are assigned a probability of default based on their
      unique credit characteristics and market
  indicators.


·
            Severity
      of Loss – In addition to the probability of default discussed above, a
      severity of loss (projected recovery) is determined in all cases. In the
      current analysis, the severity of loss ranges from 0% to 100% depending on
      the estimated credit worthiness of the individual issuer, with a 95%
      severity of loss utilized for deferrals projected in 2011 and
      thereafter.





In
addition to the above factors, the evaluation of impairment also includes a
stress test analysis which provides an estimate of future risk for each tranche.
This stressed breakpoint is then compared to the level of assets with credit
concerns in each tranche. This comparison allows management to identify those
pools that are at a greater risk for a future adverse change in cash flows so
that we can monitor the asset quality in those pools more closely for potential
deterioration of credit quality.


- 17
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





7.
INVESTMENT SECURITIES (Continued)





Based
upon the analysis performed by management as of September 30, 2010, the expected
principal shortfall on one out of eight pooled trust preferred securities has
resulted in a $51,000 credit related OTTI charge in the third quarter of 2010.
For the nine-month period ended September 30, 2010 total credit related OTTI
charges of $277,000 were recorded on three pooled trust preferred securities.
This compares to credit related OTTI charges on debt securities of $753,000 and
$761,000 for the three and nine months ended September 30, 2009 and $1,002,000
for the year ended December 31, 2009.





8.
LOANS & ALLOWANCE FOR LOAN LOSSES





The
following table presents loans by category as of September 30, 2010 and December
31, 2009:


September 30, 2010
                            
                            
                            December 31, 2009Commercial
      and industrial
                            
                            $
                            105,425
                            
                            
                            $
                            104,523Construction
                            
                            
                            16,961
                            
                            
                            
                            27,567Real
      estate-commercial
                            
                            
                            210,873
                            
                            
                            
                            173,019Real
      estate-residential
                            
                            
                            130,575
                            
                            
                            
                            128,825Consumer
                            
                            
                            2,822
                            
                            
                            
                            3,702Indirect
      lease financing
                            
                            
                            11,272
                            
                            
                            
                            11,826Total
      loans
                            
                            
                            477,928
                            
                            
                            
                            449,462Net
      unearned (fees) costs
                            
                            
                            12
                            
                            
                            
                            (41
                            )Loans
      receivable
                            
                            $
                            477,940
                            
                            
                            $
                            449,421





Activity
in the allowance for loan losses is shown below:


Three Months Ended
                            
                            
                            Nine Months EndedSeptember 30,
                            
                            
                            September 30,2010
                            
                            
                            2009
                            
                            
                            2010
                            
                            
                            2009Balance
      at beginning of period
                            
                            $
                            7,009
                            
                            
                            $
                            4,584
                            
                            
                            $
                            6,217
                            
                            
                            $
                            3,836Charge-offs
                            
                            
                            (139
                            )
                            
                            
                            (585
                            )
                            
                            
                            (917
                            )
                            
                            
                            (992
                            )Recoveries
                            
                            
                            62
                            
                            
                            
                            74
                            
                            
                            
                            232
                            
                            
                            
                            129Net
      charge-offs
                            
                            
                            (77
                            )
                            
                            
                            (511
                            )
                            
                            
                            (685
                            )
                            
                            
                            (863
                            )Provision
      for loan losses
                            
                            
                            1,200
                            
                            
                            
                            1,500
                            
                            
                            
                            2,600
                            
                            
                            
                            2,600Balance
      at end of period
                            
                            $
                            8,132
                            
                            
                            $
                            5,573
                            
                            
                            $
                            8,132
                            
                            
                            $
                            5,573





A loan is
considered impaired when it is probable that interest and principal will not be
collected according to the contractual terms of the loan agreement. Information
with respect to loans that are considered to be impaired at September 30, 2010
and December 31, 2009 is as follows:


At
      September 30, 2010
                                  
                                  
                                  At
      December 31, 2009Balance
                                  
                                  
                                  Specific
                                    reserve
                                  
                                  
                                  Balance
                                  
                                  
                                  Specific
                                    reserveRecorded
      investment in impaired loans at period-end subject to a specific reserve
      for loan losses and corresponding specific reserve
                                  
                                  $
                                  6,601
                                  
                                  
                                  $
                                  1,391
                                  
                                  
                                  $
                                  1,077
                                  
                                  
                                  $
                                  528Recorded
      investment in impaired loans at period-end requiring no specific reserve
      for loan losses
                                  
                                  
                                  7,597
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  4,622Recorded
      investment in impaired loans at period-end
                                  
                                  $
                                  14,198
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  5,699




- 18
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





9.
FAIR VALUE MEASUREMENTS AND DISCLOSURES





Financial
Accounting Standards Board (FASB) ASC 820, Fair Value Measurements and
Disclosures, defines fair value as an exit price, representing the amount
that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants (fair values are not adjusted
for transaction costs). ASC 820 also establishes a framework (fair value
hierarchy) for measuring fair value under GAAP, and expands disclosures about
fair value measurements.





ASC 820
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 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).





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.





The
measurement of fair value should be consistent with one of the following
valuation techniques: market approach, income approach, and/or cost approach.
The market approach uses prices and other relevant information generated by
market transactions involving identical or comparable assets or liabilities
(including a business). For example, valuation techniques consistent with the
market approach often use market multiples derived from a set of comparables.
Multiples might lie in ranges with a different multiple for each comparable. The
selection of where within the range the appropriate multiple falls requires
judgment, considering factors specific to the measurement (qualitative and
quantitative). Valuation techniques consistent with the market approach include
matrix pricing. Matrix pricing is a mathematical technique used principally to
value debt securities without relying exclusively on quoted prices for the
specific securities, but rather by relying on the security’s relationship to
other benchmark quoted securities.





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


September 30, 2010
                          
                          Quoted Prices in
                            Active Markets for
                            Identical Assets
                            (Level 1)
                          
                          
                          Significant Other
                            Observable Input
                            (Level 2)
                          
                          
                          Significant
                            Unobservable
                            Inputs (Level 3)
                          
                          
                          Balance at End of
                            PeriodSecurities
      available-for-saleU.S.
      Treasury
                          
                          $
                          4,515
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          $
                          4,515U.S.
      Government agencies
                          
                          
                          -
                          
                          
                          $
                          63,073
                          
                          
                          
                          -
                          
                          
                          
                          63,073State
      and municipal securities
                          
                          
                          -
                          
                          
                          
                          61,333
                          
                          
                          
                          -
                          
                          
                          
                          61,333U.S.
      Government agencies and sponsored enterprises (GSEs) -
      residentialMortgage-backed
      securities
                          
                          
                          -
                          
                          
                          
                          72,976
                          
                          
                          
                          -
                          
                          
                          
                          72,976Collateralized
      mortgage obligations (CMOs)
                          
                          
                          -
                          
                          
                          
                          71,760
                          
                          
                          
                          -
                          
                          
                          
                          71,760Other
      debt securities
                          
                          
                          -
                          
                          
                          
                          529
                          
                          
                          $
                          1,665
                          
                          
                          
                          2,194Equity
      securities
                          
                          
                          3,400
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          3,400Total
                          
                          $
                          7,915
                          
                          
                          $
                          269,671
                          
                          
                          $
                          1,665
                          
                          
                          $
                          279,251




- 19
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





9.
FAIR VALUE MEASUREMENTS AND DISCLOSURES (Continued)





December 31, 2009
                          
                          Quoted Prices in
                            Active Markets for
                            Identical Assets
                            (Level1)
                          
                          
                          Significant Other
                            Observable Input
                            (Level 2)
                          
                          
                          Significant
                            Unobservable
                            Inputs (Level 3)
                          
                          
                          Balance at End of
                            PeriodSecurities
      available-for-saleU.S.
      Treasury
                          
                          $
                          5,013
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          $
                          5,013U.S.
      Government agencies
                          
                          
                          -
                          
                          
                          $
                          69,731
                          
                          
                          
                          -
                          
                          
                          
                          69,731State
      and municipal securities
                          
                          
                          -
                          
                          
                          
                          54,160
                          
                          
                          
                          -
                          
                          
                          
                          54,160U.S.
      Government agencies and sponsored enterprises (GSEs) -
      residentialMortgage-backed
      securities
                          
                          
                          -
                          
                          
                          
                          61,649
                          
                          
                          
                          -
                          
                          
                          
                          61,649Collateralized
      mortgage obligations (CMOs)
                          
                          
                          -
                          
                          
                          
                          61,317
                          
                          
                          
                          -
                          
                          
                          
                          61,317Other
      debt securities
                          
                          
                          -
                          
                          
                          
                          525
                          
                          
                          $
                          1,008
                          
                          
                          
                          1,533Equity
      securities
                          
                          
                          3,459
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          3,459Total
                          
                          $
                          8,472
                          
                          
                          $
                          247,382
                          
                          
                          $
                          1,008
                          
                          
                          $
                          256,862





The
following table presents additional information about the securities
available-for-sale measured at fair value on a recurring basis and for which QNB
utilized significant unobservable inputs (Level 3 inputs) to determine fair
value:


Balance at
                    June 30
                  
                  
                  Total
                    Unrealized
                    Gains
                  
                  
                  Total
                    Realized
                    Losses
                  
                  
                  Purchases
                    (Sales or
                    Paydowns)
                  
                  
                  Balance at
                    September 30For
      the Three Months Ended September 30, 2010Securities
      available-for-sale
                  
                  $
                  1,698
                  
                  
                  $
                  173
                  
                  
                  $
                  (51
                  )
                  
                  $
                  (155
                  )
                  
                  $
                  1,665For
      the Three Months Ended September 30, 2009Securities
      available-for-sale
                  
                  $
                  829
                  
                  
                  $
                  1,203
                  
                  
                  $
                  (753
                  )
                  
                  $
                  5
                  
                  
                  $
                  1,284





Balance at
                    December 31
                  
                  
                  Total
                    Unrealized
                    Gains or
                    (Losses)
                  
                  
                  Total
                    Realized
                    Losses
                  
                  
                  Purchases
                    (Sales or
                    Paydowns)
                  
                  
                  Balance at
                    September 30For
      the Nine Months Ended September 30, 2010Securities
      available-for-sale
                  
                  $
                  1,008
                  
                  
                  $
                  1,090
                  
                  
                  $
                  (277
                  )
                  
                  $
                  (156
                  )
                  
                  $
                  1,665For
      the Nine Months Ended September 30, 2009Securities
      available-for-sale
                  
                  $
                  1,963
                  
                  
                  $
                  68
                  
                  
                  $
                  (761
                  )
                  
                  $
                  14
                  
                  
                  $
                  1,284





There
were no transfers in and out of Level 1 and Level 2 fair value measurements
during the period ended September 30, 2010. There were also no transfers in or
out of level 3 for the nine months ended September 30, 2010 and 2009. There were
$51,000 and $277,000 of losses included in earnings attributable to the change
in unrealized gains or losses relating to the available-for-sale securities
above with fair value measurements utilizing significant unobservable inputs for
the three and nine-month periods ended September 30, 2010, respectively. The
amount included in earnings for 2009 were $753,000 and $761,000 for the three
and nine-month periods ended September 30.


- 20
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





9.
FAIR VALUE MEASUREMENTS AND DISCLOSURES (Continued)





The Level
3 securities consist of eight collateralized debt obligation securities that are
backed by trust preferred securities issued by banks, thrifts, and insurance
companies (PreTSLs). The market for these securities at September 30, 2010 is
not active and markets for similar securities are also not active. The
inactivity was evidenced first by a significant widening of the bid-ask spread
in the brokered markets in which PreTSLs trade and then by a significant
decrease in the volume of trades relative to historical levels. The new issue
market is also inactive and there are currently very few market participants who
are willing and or able to transact for these securities.





Given
conditions in the debt markets today and the absence of observable transactions
in the secondary and new issue markets, we determined:


·
            The
      few observable transactions and market quotations that are available are
      not reliable for purposes of determining fair value at September 30,
      2010;


·
            An
      income valuation approach technique (present value technique) that
      maximizes the use of relevant observable inputs and minimizes the use of
      unobservable inputs will be equally or more representative of fair value
      than the market approach valuation technique used at prior measurement
      dates; and


·
            PreTSLs
      will be classified within Level 3 of the fair value hierarchy because
      significant adjustments are required to determine fair value at the
      measurement date.





The Bank
is aware of several factors indicating that recent transactions of PreTSL
securities are not orderly including an increased spread between bid/ask prices,
lower sales transaction volumes for these types of securities, and a lack of new
issuances. As a result, the Bank engaged an independent third party to value the
securities using a discounted cash flow analysis. The estimated cash flows are
based on specific assumptions about defaults, deferrals and prepayments of the
trust preferred securities underlying each PreTSL. The resulting collateral cash
flows are allocated to the bond waterfall using the INTEX desktop valuation
model.





The
estimates for the conditional default rates (CDR) are based on the payment
characteristics of the trust preferred securities themselves (e.g. current,
deferred, or defaulted) as well as the financial condition of the trust
preferred issuers in the pool. A near-term CDR for each issuer in the pool is
estimated based on their financial condition using key financial ratios relating
to the financial institution’s capitalization, asset quality, profitability and
liquidity. In addition to the specific bank default assumptions, default rates
are modeled to migrate to three times historic norms for 2011 and two times
historic levels throughout 2012. In 2013 and beyond the CDR rate is calculated
based upon individual issuers’ estimated CAMEL rating as projected by
VERIBANC®.





The base
loss severity assumption is 95%. The severity factor for near-term CDRs is
vectored to reflect the relative expected performance of the institutions
modeled to default, with lower forecasted severities used for the higher quality
institutions. The long-term loss severity is modeled at 95%.





Prepayments
are modeled to take into account the disruption in the asset-backed securities
marketplace and the lack of new trust preferred issuances. For purposes of
the cash flow analysis, relatively modest rates of prepayment were forecasted
(ranging from 0-2%). In addition to the base prepayment assumption, due to
the recent enactment of the Dodd-Frank financial legislation additional
prepayment analysis was performed. First, all fixed rate trust preferred
securities issued by banks with more than $15 billion in total assets at
December 31, 2009 were identified. Next the holding companies’ approximate cost
of long-term funding given their rating and marketplace interest rates were
estimated. The following assumption was made; any holding company that
could refinance for a cost savings of more than 2% will refinance and will do so
on January 1, 2013, or January 1, 2015 for bank holding company subsidiaries of
foreign banking organizations that have relied on Supervision and Regulation
Letter SR-01-1.


- 21
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





9.
FAIR VALUE MEASUREMENTS AND DISCLOSURES (Continued)





The
internal rate of return is the pre-tax yield used to discount the best estimate
of future cash flows after credit losses. The cash flows have been discounted
using estimated market discount rates of 3 month LIBOR plus spreads ranging from
6.59% to 10.50%. The determination of appropriate market discount rates involved
the consideration of the following:


·
            the
      time value of money


·
            the
      price for bearing uncertainty in cash
flows


·
            other
      factors that would be considered by market
  participants


The
analysis of discount rates involved the review of corporate bond spreads for
banks, U.S. Treasury yields, credit default swap rates for financial companies
(utilized as a proxy for credit), the swap/LIBOR yield curve and the
characteristics of the individual securities being valued.





For
assets measured at fair value on a non-recurring basis, the fair value
measurements by level within the fair value hierarchy are as
follows:


Quoted Prices in
                    Active Markets for
                    Identical Assets
                    (Level 1)
                  
                  
                  Significant Other
                    Observable Input
                    (Level 2)
                  
                  
                  Significant
                    Unobservable
                    Inputs (Level 3)
                  
                  
                  Balance at End of
                    PeriodSeptember
      30, 2010Impaired
      loans, net
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  5,210
                  
                  
                  $
                  5,210Mortgage
      servicing rights
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  497
                  
                  
                  
                  497December
      31, 2009Foreclosed
      assets
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  67
                  
                  
                  $
                  67Mortgage
      servicing rights
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  519
                  
                  
                  
                  519Impaired
      loans
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  549
                  
                  
                  
                  549





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 QNB’s assets and liabilities. Due to a wide range of
valuation techniques and the degree of subjectivity used in making the
estimates, comparisons between QNB’s disclosures and those of other companies
may not be meaningful.





The
following methods and assumptions were used to estimate the fair values of each
major classification of financial instrument and non-financial asset at
September 30, 2010 and December 31, 2009:





Cash and due from banks,
interest-bearing deposits in banks, Federal funds sold, accrued interest
receivable and accrued interest payable (carried at cost): The carrying
amounts reported in the balance sheet approximate those assets’ fair
value.





Investment securities
available for sale (carried at fair value) and held-to-maturity (carried at
amortized cost): The fair value of securities 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. 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.


- 22
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





9.
FAIR VALUE MEASUREMENTS AND DISCLOSURES (Continued)





At
September 30, 2010, the Company determined that no active market existed for
pooled trust preferred securities with an amortized cost of $3,640,000 and an
estimated fair value of $1,655,000. At December 31, 2009, the Company determined
that no active market existed for pooled trust preferred securities with an
amortized cost of $4,073,000 and an estimated fair value of
$1,008,000.





Restricted investment in
bank stocks (carried at cost): The fair value of stock in Atlantic
Central Bankers Bank and the Federal Home Loan Bank is the carrying amount,
based on redemption provisions, and considers the limited marketability of such
securities.





Loans Held for Sale (carried
at lower of cost or fair value): The fair value of loans held for sale is
determined, when possible, using quoted secondary market prices. If no such
quoted prices exist, the fair value of a loan is determined using quoted prices
for a similar loan or loans, adjusted for the specific attributes of that
loan.





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.





Impaired Loans (generally
carried at fair value): Impaired loans are loans, in which the Company
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 of impaired loans as of September 30, 2010 consists
of loan balances of $6,601,000 less a valuation allowance of $1,391,000. The
fair value of impaired loans as of December 31, 2009 consists of loan balances
of $1,077,000 less a valuation allowance of $528,000.





Mortgage Servicing Rights
(carried at lower of cost or fair value): The fair value of mortgage
servicing rights is based on a valuation model that calculates the present value
of estimated net servicing income. The mortgage servicing rights are startified
into tranches based on predominant characteristics, such as interest rate, loan
type and investor type. The valuation incorporates assumptions that market
participants would use in estimating future net servicing income.





Certain
tranches of mortgage servicing rights, which are carried at lower of cost or
fair value, were written down to fair value during the quarter. The ending
valuation allowance is $13,000 at September 30, 2010.





Foreclosed assets (other
real estate owned and repossessed assets): Foreclosed assets are the only
non-financial assets valued on a non-recurring basis which are held by the
Company at fair value, less cost to sell. At foreclosure or repossession, if the
fair value, less estimated costs to sell, of the collateral acquired (real
estate, vehicles, equipment) is less than the Company’s recorded investment in
the related loan, a write-down is recognized through a charge to the allowance
for loan losses. Additionally, valuations are periodically performed by
management and any subsequent reduction in value is recognized by a charge to
income. The fair value of foreclosed assets held-for-sale is estimated using
Level 3 inputs based on observable market data.





Deposit liabilities (carried
at cost): The fair value of deposits with no stated maturity (e.g. demand
deposits, interest-bearing demand accounts, money market accounts and savings
accounts) are by definition, equal to the amount payable on demand at the
reporting date (i.e. their carrying amounts). This approach to estimating fair
value excludes the significant benefit that results from the low-cost funding
provided by such deposit liabilities, as compared to alternative sources of
funding. Deposits with a stated maturity (time deposits) have been valued using
the present value of cash flows discounted at rates approximating the current
market for similar deposits.


- 23
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





9.
FAIR VALUE MEASUREMENTS AND DISCLOSURES (Continued)





Short-term borrowings
(carried at cost): The carrying amount of short-term borrowings
approximates their fair values.





Long-term debt (carried at
cost): The fair values of FHLB advances and securities sold under
agreements to repurchase are estimated using discounted cash flow analysis,
based on quoted prices for new long-term debt with similar credit risk
characteristics, terms and remaining maturity. These prices obtained from this
active market represent a fair value that is deemed to represent the transfer
price if the liability were assumed by a third party.





Off-balance-sheet
instruments (disclosed at cost): The fair values for the Bank’s
off-balance sheet 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.





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 the respective period 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 period end.





The
estimated fair values and carrying amounts of the Company’s financial
instruments are summarized as follows:


September 30, 2010
                      
                      
                      December 31, 2009Carrying
                      
                      
                      Estimated
                      
                      
                      Carrying
                      
                      
                      EstimatedAmount
                      
                      
                      Fair Value
                      
                      
                      Amount
                      
                      
                      Fair ValueFinancial
      AssetsCash
      and due from banks
                      
                      $
                      8,014
                      
                      
                      $
                      8,014
                      
                      
                      $
                      8,841
                      
                      
                      $
                      8,841Interest-bearing
      deposits in banks
                      
                      
                      4,052
                      
                      
                      
                      4,052
                      
                      
                      
                      22,158
                      
                      
                      
                      22,158Investment
      securities available-for-sale
                      
                      
                      279,251
                      
                      
                      
                      279,251
                      
                      
                      
                      256,862
                      
                      
                      
                      256,862Investment
      securities held-to-maturity
                      
                      
                      2,847
                      
                      
                      
                      2,944
                      
                      
                      
                      3,347
                      
                      
                      
                      3,471Restricted
      investment in bank stocks
                      
                      
                      2,291
                      
                      
                      
                      2,291
                      
                      
                      
                      2,291
                      
                      
                      
                      2,291Loans
      held-for-sale
                      
                      
                      968
                      
                      
                      
                      999
                      
                      
                      
                      534
                      
                      
                      
                      537Net
      loans
                      
                      
                      469,808
                      
                      
                      
                      458,946
                      
                      
                      
                      443,204
                      
                      
                      
                      423,036Mortgage
      servicing rights
                      
                      
                      497
                      
                      
                      
                      551
                      
                      
                      
                      519
                      
                      
                      
                      637Accrued
      interest receivable
                      
                      
                      2,968
                      
                      
                      
                      2,968
                      
                      
                      
                      2,848
                      
                      
                      
                      2,848Financial
      LiabilitiesDeposits
      with no stated maturities
                      
                      
                      362,788
                      
                      
                      
                      362,788
                      
                      
                      
                      313,007
                      
                      
                      
                      313,007Deposits
      with stated maturities
                      
                      
                      311,459
                      
                      
                      
                      314,110
                      
                      
                      
                      321,096
                      
                      
                      
                      323,437Short-term
      borrowings
                      
                      
                      31,173
                      
                      
                      
                      31,173
                      
                      
                      
                      28,433
                      
                      
                      
                      28,433Long-term
      debt
                      
                      
                      20,311
                      
                      
                      
                      21,955
                      
                      
                      
                      35,000
                      
                      
                      
                      36,559Accrued
      interest payable
                      
                      
                      1,174
                      
                      
                      
                      1,174
                      
                      
                      
                      1,565
                      
                      
                      
                      1,565





The
estimated fair value of QNB’s off-balance sheet financial instruments is as
follows:


September 30, 2010
                        
                        
                        December 31, 2009Notional
                        
                        
                        Estimated
                        
                        
                        Notional
                        
                        
                        EstimatedAmount
                        
                        
                        Fair Value
                        
                        
                        Amount
                        
                        
                        Fair ValueCommitments
      to extend credit
                        
                        $
                        102,155
                        
                        
                        $
                        -
                        
                        
                        $
                        99,119
                        
                        
                        $
                        -Standby
      letters of credit
                        
                        
                        14,614
                        
                        
                        
                        -
                        
                        
                        
                        14,071
                        
                        
                        
                        -


- 24
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





10.
OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS AND GUARANTEES





In the
normal course of business there are various legal proceedings, commitments, and
contingent liabilities which are not reflected in the financial statements.
Management does not anticipate any material losses as a result of these
transactions and activities. They include, among other things, commitments to
extend credit and standby letters of credit. The maximum exposure to credit
loss, which represents the possibility of sustaining a loss due to the failure
of the other parties to a financial instrument to perform according to the terms
of the contract, is represented by the contractual amount of these instruments.
QNB uses the same lending standards and policies in making credit commitments as
it does for on-balance sheet instruments. The activity is controlled through
credit approvals, control limits, and monitoring procedures.





A summary
of the Bank's financial instrument commitments is as follows:


September 30, 2010
                  
                  
                  December 31, 2009Commitments
      to extend credit and unused lines of credit
                  
                  $
                  102,155
                  
                  
                  $
                  99,119Standby
      letters of credit
                  
                  
                  14,614
                  
                  
                  
                  14,071$
                  116,769
                  
                  
                  $
                  113,190





Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract. Commitments generally
have fixed expiration dates or other termination clauses and may require the
payment of a fee. Since many of the commitments are expected to expire without
being drawn upon, the total commitment amounts do not necessarily represent
future cash requirements. QNB evaluates each customer’s creditworthiness on a
case-by-case basis.





Standby
letters of credit are conditional commitments issued by the Bank to guarantee
the financial or performance obligation of a customer to a third party. QNB’s
exposure to credit loss in the event of nonperformance by the other party to the
financial instrument for standby letters of credit is represented by the
contractual amount of those instruments. The Bank uses the same credit policies
in making conditional obligations as it does for on-balance sheet instruments.
These standby letters of credit expire within three years. The credit risk
involved in issuing letters of credit is essentially the same as that involved
in extending other loan commitments. The Bank requires collateral and personal
guarantees supporting these letters of credit as deemed necessary. Management
believes that the proceeds obtained through a liquidation of such collateral and
the enforcement of personal guarantees would be sufficient to cover the maximum
potential amount of future payments required under the corresponding guarantees.
The amount of the liability as of September 30, 2010 and December 31, 2009 for
guarantees under standby letters of credit issued is not material.





The
amount of collateral obtained for letters of credit and commitments to extend
credit is based on management’s credit evaluation of the customer. Collateral
varies, but may include real estate, accounts receivable, marketable securities,
pledged deposits, inventory or equipment.





11.
REGULATORY RESTRICTIONS





Dividends
payable by the Company and the Bank are subject to various limitations imposed
by statutes, regulations and policies adopted by bank regulatory agencies. Under
Pennsylvania banking law, the Bank is subject to certain restrictions on the
amount of dividends that it may declare without prior regulatory approval. Under
Federal Reserve regulations, the Bank is limited as to the amount it may lend
affiliates, including the Company, unless such loans are collateralized by
specific obligations.


- 25
-


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





11.
REGULATORY RESTRICTIONS (Continued)





Both the
Company and the Bank are subject to regulatory capital requirements administered
by Federal banking agencies. Failure to meet minimum capital requirements can
initiate actions by regulators that could have an effect on the financial
statements. Under the framework for prompt corrective action, both the Company
and the Bank must meet capital guidelines that involve quantitative measures of
their assets, liabilities, and certain off-balance-sheet items. The capital
amounts and classification are also subject to qualitative judgments by the
regulators. Management believes, as of September 30, 2010, that the Company and
the Bank met capital adequacy requirements to which they were
subject.





As of the
most recent notification, the primary regulator of the Bank considered it to be
“well capitalized” under the regulatory framework. There are no conditions or
events since that notification that management believes have changed the
classification. To be categorized as well capitalized, the Company and the Bank
must maintain minimum ratios as set forth in the table below.





The
Company and the Bank’s actual capital amounts and ratios are presented as
follows:


Capital LevelsActual
                                      
                                      
                                      Adequately Capitalized
                                      
                                      
                                      Well CapitalizedAs of September 30, 2010
                                      
                                      Amount
                                      
                                      
                                      Ratio
                                      
                                      
                                      Amount
                                      
                                      
                                      Ratio
                                      
                                      
                                      Amount
                                      
                                      
                                      RatioTotal
      Risk-Based Capital (to Risk Weighted Assets)Consolidated
                                      
                                      $
                                      65,441
                                      
                                      
                                      
                                      11.64
                                      %
                                      
                                      $
                                      44,987
                                      
                                      
                                      
                                      8.00
                                      %
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      N/ABank
                                      
                                      
                                      61,586
                                      
                                      
                                      
                                      11.02
                                      %
                                      
                                      
                                      44,712
                                      
                                      
                                      
                                      8.00
                                      %
                                      
                                      $
                                      55,889
                                      
                                      
                                      
                                      10.00
                                      %Tier
      I Capital (to Risk Weighted Assets)Consolidated
                                      
                                      
                                      58,275
                                      
                                      
                                      
                                      10.36
                                      %
                                      
                                      
                                      22,493
                                      
                                      
                                      
                                      4.00
                                      %
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      N/ABank
                                      
                                      
                                      54,586
                                      
                                      
                                      
                                      9.77
                                      %
                                      
                                      
                                      22,356
                                      
                                      
                                      
                                      4.00
                                      %
                                      
                                      
                                      33,534
                                      
                                      
                                      
                                      6.00
                                      %Tier
      I Capital (to Average Assets)Consolidated
                                      
                                      
                                      58,275
                                      
                                      
                                      
                                      7.43
                                      %
                                      
                                      
                                      31,380
                                      
                                      
                                      
                                      4.00
                                      %
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      N/ABank
                                      
                                      
                                      54,586
                                      
                                      
                                      
                                      6.99
                                      %
                                      
                                      
                                      31,243
                                      
                                      
                                      
                                      4.00
                                      %
                                      
                                      
                                      39,054
                                      
                                      
                                      
                                      5.00
                                      %





Capital LevelsActual
                      
                      
                      Adequately Capitalized
                      
                      
                      Well CapitalizedAs of December 31, 2009
                      
                      Amount
                      
                      
                      Ratio
                      
                      
                      Amount
                      
                      
                      Ratio
                      
                      
                      Amount
                      
                      
                      RatioTotal
      Risk-Based Capital (to Risk Weighted Assets)Consolidated
                      
                      $
                      61,168
                      
                      
                      
                      11.51
                      %
                      
                      $
                      42,504
                      
                      
                      
                      8.00
                      %
                      
                      
                      N/A
                      
                      
                      
                      N/ABank
                      
                      
                      57,436
                      
                      
                      
                      10.89
                      %
                      
                      
                      42,212
                      
                      
                      
                      8.00
                      %
                      
                      $
                      52,765
                      
                      
                      
                      10.00
                      %Tier
      I Capital (to Risk Weighted Assets)Consolidated
                      
                      
                      54,703
                      
                      
                      
                      10.30
                      %
                      
                      
                      21,252
                      
                      
                      
                      4.00
                      %
                      
                      
                      N/A
                      
                      
                      
                      N/ABank
                      
                      
                      51,219
                      
                      
                      
                      9.71
                      %
                      
                      
                      21,106
                      
                      
                      
                      4.00
                      %
                      
                      
                      31,659
                      
                      
                      
                      6.00
                      %Tier
      I Capital (to Average Assets)Consolidated
                      
                      
                      54,703
                      
                      
                      
                      7.34
                      %
                      
                      
                      29,822
                      
                      
                      
                      4.00
                      %
                      
                      
                      N/A
                      
                      
                      
                      N/ABank
                      
                      
                      51,219
                      
                      
                      
                      6.90
                      %
                      
                      
                      29,679
                      
                      
                      
                      4.00
                      %
                      
                      
                      37,099
                      
                      
                      
                      5.00
                      %


- 26
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





ITEM
      2.
            MANAGEMENT'S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS





QNB Corp.
(herein referred to as QNB or the Company) is a bank holding company
headquartered in Quakertown, Pennsylvania. The Company, through its wholly-owned
subsidiary, QNB Bank (the Bank), has been serving the residents and businesses
of upper Bucks, northern Montgomery and southern Lehigh counties in Pennsylvania
since 1877. The Bank is a locally managed community bank that provides a full
range of commercial and retail banking and retail brokerage
services.





Tabular
information presented throughout management’s discussion and analysis, other
than share and per share data, is presented in thousands of
dollars.





FORWARD-LOOKING
STATEMENTS





In
addition to historical information, this document contains forward-looking
statements. Forward-looking statements are typically identified by words or
phrases such as “believe,” “expect,” “anticipate,” “intend,” “estimate,”
“project” and variations of such words and similar expressions, or future or
conditional verbs such as “will,” “would,” “should,” “could,” “may” or similar
expressions. The U.S. Private Securities Litigation Reform Act of 1995 provides
safe harbor in regard to the inclusion of forward-looking statements in this
document and documents incorporated by reference.





Shareholders
should note that many factors, some of which are discussed elsewhere in this
document and in the documents that are incorporated by reference, and including
the risk factors identified in Item 1A of QNB’s 2009 Form 10-K, could affect the
future financial results of the Company and its subsidiary and could cause those
results to differ materially from those expressed in the forward-looking
statements contained or incorporated by reference in this document. These
factors include, but are not limited, to the following:


·
            Volatility
      in interest rates and shape of the yield
curve;


·
            Credit
      risk;


·
            Liquidity
      risk;


·
            Operating,
      legal and regulatory risks including new laws
  passed;


·
            Economic,
      political and competitive forces affecting the Company’s line of
      business;


·
            The
      risk that the Federal Deposit Insurance Corporation (FDIC) could levy
      additional insurance assessments on all insured institutions in order to
      replenish the Deposit Insurance Fund based on the level of bank failures
      in the future; and


·
            The
      risk that the analysis of these risks and forces could be incorrect,
      and/or that the strategies developed to address them could be
      unsuccessful.





QNB
cautions that these forward-looking statements are subject to numerous
assumptions, risks and uncertainties, all of which change over time, and QNB
assumes no duty to update forward-looking statements. Management cautions
readers not to place undue reliance on any forward-looking statements. These
statements speak only as of the date of this report on Form 10-Q, even if
subsequently made available by QNB on its website or otherwise, and they advise
readers that various factors, including those described above, could affect
QNB’s financial performance and could cause actual results or circumstances for
future periods to differ materially from those anticipated or projected. Except
as required by law, QNB does not undertake, and specifically disclaims any
obligation, to publicly release any revisions to any forward-looking statements
to reflect the occurrence of anticipated or unanticipated events or
circumstances after the date of such statements.


- 27
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





RECENT
LEGISLATION AFFECTING THE FINANCIAL SERVICES INDUSTRY





The
Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”)
was signed into law on July 21, 2010. The Dodd-Frank Act contains numerous and
wide-ranging reforms to the structure and operation of the U.S. financial
system. Among the Dodd-Frank Act’s significant regulatory changes are
(i) the imposition of more stringent capital requirements on bank holding
companies by, among other things, imposing leverage ratios and prohibiting new
trust preferred issuances from counting as Tier 1 capital; (ii) making
permanent the temporary increase in FDIC deposit insurance coverage from
$100,000 to $250,000 and providing for unlimited deposit insurance on
noninterest-bearing transaction accounts, together with an increase in the
minimum Deposit Insurance Fund reserve requirement and a change in the
assessment base from deposits to net assets; (iii) the creation of the
Consumer Financial Protection Bureau, a new financial consumer protection
agency, which is empowered to promulgate new consumer protection regulations and
revise existing regulations in many areas of consumer compliance;
(iv) provisions eliminating the federal prohibitions on paying interest on
demand deposits, thus allowing businesses to have interest bearing checking
accounts, effective one year after the date of enactment; (v) increased
regulation of derivatives and hedging transactions and restrictions on an
institution’s ability to engage in certain proprietary trading and investing
activities; (vi) limitations on debit card interchange fees; (vii) the
imposition of new disclosure and other requirements related to corporate
governance and executive compensation; and (viii) the creation of the
Financial Stability Oversight Council, with responsibility for identifying and
monitoring systemic risks posed by financial firms, activities and
practices.





QNB is
currently evaluating the potential impact of the Dodd-Frank Act on its business,
financial condition and results of operations. Management expects that some
provisions of the Dodd-Frank Act may have adverse effects on QNB, such as the
cost of complying with numerous new regulations and disclosure and reporting
requirements mandated by the Dodd-Frank Act. Portions of the Dodd-Frank Act
become effective at different times, and many of the Dodd-Frank Act’s provisions
consist of general statements directing various regulators to issue more
detailed rules. Consequently, the full scope of the Dodd-Frank Act’s impact on
the financial system in general and QNB in particular cannot be predicted at
this time.





CRITICAL
ACCOUNTING POLICIES AND ESTIMATES





The
discussion and analysis of the financial condition and results of operations are
based on the consolidated financial statements of QNB, which are prepared in
accordance with U.S. generally accepted accounting principles (GAAP) and
predominant practices within the banking industry. The preparation of these
consolidated financial statements requires QNB to make estimates and judgments
that affect the reported amounts of assets, liabilities, revenues and expenses,
and related disclosure of contingent assets and liabilities. QNB evaluates
estimates on an on-going basis, including those related to the determination of
the allowance for loan losses, the determination of the valuation of other real
estate owned and foreclosed assets, other-than-temporary impairments on
investment securities, the determination of impairment of restricted bank stock,
the valuation of deferred tax assets, stock-based compensation and income taxes.
QNB bases its estimates on historical experience and various other factors and
assumptions that are believed to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities that are not readily apparent from other sources.
Actual results may differ from these estimates under different assumptions or
conditions.





Other-Than-Temporary
Investment Security Impairment


Securities
are evaluated periodically to determine whether a decline in their value is
other-than-temporary. Management utilizes criteria such as the magnitude and
duration of the decline, in addition to the reasons underlying the decline, to
determine whether the loss in value is other-than-temporary. The term
“other-than-temporary” is not intended to indicate that the decline is
permanent, but indicates that the prospect for a near-term recovery of value is
not necessarily favorable, or that there is a lack of evidence to support a
realizable value equal to or greater than the carrying value of the investment.
For equity securities, once a decline in value is determined to be
other-than-temporary, the value of the equity security is reduced and a
corresponding charge to earnings is recognized.


- 28
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





CRITICAL
ACCOUNTING POLICIES AND ESTIMATES (Continued)





Effective
April 1, 2009, the Company adopted new accounting guidance related to
recognition and presentation of other-than-temporary impairment. This accounting
guidance amends the recognition guidance for other-than-temporary impairments of
debt securities and expands the financial statement disclosures for
other-than-temporary impairment losses on debt securities. The recent guidance
replaced the “intent and ability” indication in previous guidance by specifying
that (a) if a company does not have the intent to sell a debt security prior to
recovery and (b) it is more likely than not that it will not have to sell the
debt security prior to recovery, the security would not be considered
other-than-temporarily impaired unless there is a credit loss. When an entity
does not intend to sell the security, and it is more likely than not, the entity
will not have to sell the security before recovery of its cost basis, it will
recognize the credit component of an other-than-temporary impairment of a debt
security in earnings and the remaining portion in other comprehensive income.
For held-to-maturity debt securities, the amount of an other-than-temporary
impairment recorded in other comprehensive income for the noncredit portion of a
previous other-than-temporary impairment should be amortized prospectively over
the remaining life of the security on the basis of the timing of future
estimated cash flows of the security.





During
the third quarter of 2010 and 2009 QNB recorded credit related
other-than-temporary impairment charges of $51,000 and $753,000 on its holdings
of pooled trust preferred securities. For the nine month period ended September
30, 2010, the Company recorded $277,000 credit related of other-than-temporary
charges on its trust preferred securities. For the same period in 2009, the
Company recorded $1,276,000 of credit related other-than-temporary impairment
charges: $761,000 related to trust preferred securities and $515,000 related to
losses in the equity securities portfolio.





Impairment
of Restricted Investment in Bank Stocks


Restricted
bank stock is comprised of restricted stock of the Federal Home Loan Bank of
Pittsburgh (FHLB) and the Atlantic Central Bankers Bank. Federal law requires a
member institution of the FHLB to hold stock of its district bank according to a
predetermined formula.





In
December 2008, the FHLB of Pittsburgh notified member banks that it was
suspending dividend payments and the repurchase of capital stock to preserve
capital. 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 restricted
stock as of September 30, 2010.





On
October 28, 2010, the FHLB announced their decision to have a limited excess
capital stock repurchase. QNB received $114,000 on October 29,
2010.





Allowance
for Loan Losses


QNB
considers that the determination of the allowance for loan losses involves a
higher degree of judgment and complexity than its other significant accounting
policies. The allowance for loan losses is calculated with the objective of
maintaining a level believed by management to be sufficient to absorb probable
known and inherent losses in the outstanding loan portfolio. The allowance is
reduced by actual credit losses and is increased by the provision for loan
losses and recoveries of previous losses. The provisions for loan losses are
charged to earnings to bring the total allowance for loan losses to a level
considered necessary by management.





The
allowance for loan losses is based on management’s continual review and
evaluation of the loan portfolio. The level of the allowance is determined by
assigning specific reserves to individually identified problem credits and
general reserves to all other loans. The portion of the allowance that is
allocated to impaired loans is determined by estimating the inherent loss on
each credit after giving consideration to the value of underlying collateral.
The general reserves are based on the composition and risk characteristics of
the loan portfolio, including the nature of the loan portfolio, credit
concentration trends, delinquency and loss experience, as well as other
qualitative factors such as current economic trends.


- 29
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





CRITICAL
ACCOUNTING POLICIES AND ESTIMATES (Continued)





Management
emphasizes loan quality and close monitoring of potential problem credits.
Credit risk identification and review processes are utilized in order to assess
and monitor the degree of risk in the loan portfolio. QNB’s lending and credit
administration staff are charged with reviewing the loan portfolio and
identifying changes in the economy or in a borrower’s circumstances which may
affect the ability to repay debt or the value of pledged collateral. A loan
classification and review system exists that identifies those loans with a
higher than normal risk of uncollectibility. Each commercial loan is assigned a
grade based upon an assessment of the borrower’s financial capacity to service
the debt and the presence and value of collateral for the loan. An independent
loan review group tests risk assessments and evaluates the adequacy of the
allowance for loan losses. Management meets monthly, or more often as required,
to review the credit quality of the loan portfolio and quarterly to review the
allowance for loan losses.





In
addition, various regulatory agencies, as an integral part of their examination
process, periodically review QNB’s allowance for loan losses. Such agencies may
require QNB to recognize additions to the allowance based on their judgments
about information available to them at the time of their
examination.





Management
believes that it uses the best information available to make determinations
about the adequacy of the allowance and that it has established its existing
allowance for loan losses in accordance with GAAP. If circumstances differ
substantially from the assumptions used in making determinations, future
adjustments to the allowance for loan losses may be necessary and results of
operations could be affected. Because future events affecting borrowers and
collateral cannot be predicted with certainty, increases to the allowance may be
necessary should the quality of any loans deteriorate as a result of the factors
discussed above.





Foreclosed
Assets


Assets
acquired through, or in lieu of, loan foreclosure are held-for-sale and are
initially recorded at fair value less cost to sell at the date of foreclosure,
establishing a new cost basis. Subsequent to foreclosure, valuations are
periodically performed by management and the assets are carried at the lower of
carrying amount or fair value less cost to sell. Revenue and expenses and
changes in the valuation allowance are included in net expenses from foreclosed
assets.





Stock-Based
Compensation


QNB
sponsors stock-based compensation plans, administered by a board committee,
under which both qualified and non-qualified stock options may be granted
periodically to certain employees. QNB accounts for all awards granted under
stock-based compensation plans in accordance with Accounting Standards
Codification (ASC) 718, Compensation-Stock Compensation. Compensation cost has
been measured using the fair value of an award on the grant date and is
recognized over the service period, which is usually the vesting period. The
fair value of each option is amortized into compensation expense on a
straight-line basis between the grant date for the option and each vesting date.
QNB estimates the fair value of stock options on the date of the grant using the
Black-Scholes option pricing model. The model requires the use of numerous
assumptions, many of which are highly subjective in nature.





Income
Taxes


QNB
accounts for income taxes under the asset/liability method in accordance with
income tax accounting guidance, ASC 740, Income Taxes. Deferred tax assets and
liabilities are recognized for the future tax consequences attributable to
differences between the financial statement carrying amounts of existing assets
and liabilities and their respective tax bases, as well as operating loss and
tax credit carryforwards. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect
on deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date. A valuation allowance is
established against deferred tax assets when, in the judgment of management, it
is more likely than not that such deferred tax assets will not become available.
Because the judgment about the level of future taxable income is dependent to a
great extent on matters that may, at least in part, be beyond QNB’s control, it
is at least reasonably possible that management’s judgment about the need for a
valuation allowance for deferred taxes could change in the near
term.


- 30
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





RESULTS
OF OPERATIONS - OVERVIEW





QNB earns
its net income primarily through its subsidiary, the Bank. Net interest income,
or the spread between the interest, dividends and fees earned on loans and
investment securities and the expense incurred on deposits and other
interest-bearing liabilities, is the primary source of operating income for QNB.
QNB seeks to achieve sustainable and consistent earnings growth while
maintaining adequate levels of capital and liquidity and limiting its exposure
to credit and interest rate risk to levels approved by the Board of Directors.
Due to its limited geographic area, comprised principally of upper Bucks,
southern Lehigh and northern Montgomery counties, growth is pursued through
expansion of existing customer relationships and building new relationships by
stressing a consistently high level of service at all points of
contact.





QNB
reported net income for the third quarter of 2010 of $1,618,000, or $0.52 per
share on a diluted basis. This compares to $671,000, or $0.22 per share on a
diluted basis, for the same period in 2009. For the nine-month period ended
September 30, 2010, QNB reported record net income of $5,407,000, or $1.74 per
share on a diluted basis. This compares to net income of $2,992,000, or $0.96
per share on a diluted basis, for the nine-month period ended September 30,
2009. Net income expressed as an annualized rate of return on average
shareholders’ equity was 12.69% for the nine-month period ended September 30,
2010 compared with 7.32% for the same period in 2009.





Earnings
for the third quarter of 2010 compared with the third quarter of 2009 reflect
higher net interest income, resulting from a widening of the net interest margin
and strong growth in loans and deposits, a reduction in the provision for loan
losses and lower other-than temporary impairment (OTTI) charges on investment
securities.





The
positive trend of increasing net interest income and net interest margin
reported earlier in 2010 continued in the third quarter. Net interest income
increased $1,114,000, or 20.2%, to $6,641,000 for the third quarter of 2010
compared to the third quarter of 2009. Net interest income for the third quarter
of 2010 also reflects an improvement of $206,000, or 3.2%, compared to the
second quarter of 2010. The net interest margin increased to 3.75% for the third
quarter of 2010 compared to 3.38% for the third quarter of 2009 and 3.74% for
the second quarter of 2010.





The
improvement in net interest income and the net interest margin compared with the
third quarter of 2009 primarily resulted from the impact of lower deposit costs
partially offset by lower yields on investment securities. The interest rate
paid on interest-bearing deposits declined by 74 basis points to 1.39% for the
third quarter of 2010 compared to the third quarter of 2009. The decline in the
rate paid on deposits largely resulted from the repricing of time deposits at
lower market rates. The average rate paid on time deposits declined 108 basis
points from 3.07% for the third quarter of 2009 to 1.99% for the third quarter
of 2010. In comparison, the average rate earned on investment securities
declined from 4.52% for the third quarter of 2009 to 3.94% for the third quarter
of 2010, a decline of 58 basis points. Negatively impacting net interest income
and the net interest margin in the third quarter of 2009 was the reversal of
$100,000 of interest income on pooled trust preferred securities placed on
non-accrual status partially offset by the recognition of a $29,000 prepayment
penalty on a commercial loan. Excluding these two items the net interest margin
would have been 3.42% in the third quarter of 2009.





QNB took
advantage of disruptions in its local banking market to obtain growth in both
loans and deposits. Average earning assets grew by $55,248,000, or 7.9%, with
average loans increasing 8.7% and average investment securities increasing 3.9%
when comparing the third quarter of 2010 to the same period in 2009. The growth
in loans was mainly related to real estate secured commercial loans and to a
lesser degree commercial and industrial loans and tax-exempt loans. On the
funding side, average deposits increased $61,096,000, or 10.0%, with average
transaction accounts increasing 26.5%, or $74,413,000. The growth in transaction
accounts is largely due to the success of QNB’s newest high-rate deposit
product, Online eSavings. The Online eSavings account was introduced in the
second quarter of 2009 and continues to experience significant growth. This
product had balances totaling $52,661,000 as of September 30, 2010 compared to
$42,253,000 at June 30, 2010 and $5,540,000 at September 30,
2009.


- 31
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





RESULTS
OF OPERATIONS – OVERVIEW (Continued)





Net
interest income increased $3,172,000, or 19.9%, to $19,100,000 comparing the
first nine months of 2010 and 2009. Over the 2010 time period, average loans and
investment securities increased 9.5% and 7.4%, respectively, and average total
deposits increased 12.5%. The net interest margin for the first nine months of
2010 was 3.71% compared to 3.42% for the first nine months of 2009, with lower
deposit costs being the primary factor in the improvement.





As a
result of loan growth, increases in non-performing, delinquent and classified
loans and continued concerns related to current economic conditions, QNB
continues to closely monitor the quality of its loan portfolio and has increased
the allowance for loan losses to reflect these conditions. QNB recorded a
provision for loan losses of $1,200,000 in the third quarter of 2010 and
$2,600,000 for the first nine months of 2010. This compares to a provision of
$1,500,000 for the third quarter of 2009 and $2,600,000 for the first nine
months of 2009. The 2010 third quarter provision also represents an increase of
$500,000 from the amount recorded in the second quarter of 2010. Net loan
charge-offs were $77,000 for the quarter ended September 30, 2010 and $685,000
for the first nine months of 2010 compared with $511,000 for the third quarter
of 2009 and $863,000 for the first nine months of 2009. QNB’s allowance for loan
losses of $8,132,000 represents 1.70% of total loans at September 30, 2010
compared to an allowance for loan losses of $5,573,000, or 1.27% of total loans
at September 30, 2009.





Total
non-performing loans, which represent loans on non-accrual status, loans past
due more than 90 days and still accruing interest, and restructured loans were
$9,908,000, or 2.07% of total loans, at September 30, 2010, compared to
$5,199,000, or 1.19% of total loans, at September 30, 2009. Total delinquent
loans, which include loans that are thirty days or more past due and non-accrual
loans, increased to 2.93% of total loans at September 30, 2010, compared with
1.93% of total loans at September 30, 2009.





Total
non-interest income was $1,004,000 for the third quarter of 2010, an increase of
$490,000 compared with the same period in 2009. Lower credit related OTTI
charges on the Bank’s holdings of pooled trust preferred securities contributed
to the improvement in non-interest income. During the third quarter of 2010
credit related OTTI charges were $51,000 compared to credit related OTTI charges
of $753,000 for the corresponding quarter of 2009. These OTTI charges were
partially offset by gains on the sale of securities of $4,000 and $103,000 for
the third quarters of 2010 and 2009, respectively.





Fees for
services to customers decreased $78,000 when comparing the third quarter of 2010
to the same 2009 quarter. The decrease was primarily caused by lower overdraft
charges as a result of the implementation of new rules under Regulation E and a
reduction in the per item fee charged to customers. ATM and debit card income
increased $54,000 while gains on the sale of residential mortgages decreased
$51,000 comparing these same periods.





Total
non-interest income for the nine month periods ended September 30, 2010 and 2009
was $3,163,000 and $2,314,000, respectively. Non-interest income for the first
nine months of 2010, excluding net investment securities gains of $22,000 and
net gains on the sale of residential mortgages of $298,000, totaled $2,843,000
compared to $2,710,000 for the first nine months of 2009, excluding net
investment securities losses of $930,000 and net gains on the sale of
residential mortgages of $534,000. Net securities gains for 2010 include credit
related OTTI charges of $277,000 on pooled trust preferred securities and net
gains of $299,000 on the sale of investments, primarily equity securities. The
net securities losses for 2009 include OTTI charges of $1,276,000; a $761,000
charge related to OTTI on the Company’s holdings of pooled trust preferred
securities and a $515,000 OTTI charge in the carrying value of holdings in the
equity investment portfolio. These charges were partially offset by realized
gains in 2009 of $346,000 on the sale of equity securities and several
higher-yielding corporate bonds sold to reduce credit risk in the
portfolio.





A
slowdown in residential mortgage activity for the first nine months of 2010
resulted in gains on sales of residential mortgage loans decreasing $236,000 to
$298,000 and also had a negative impact on the income derived from QNB’s
investment in a title company which decreased $34,000. Increases in ATM and
debit card income contributed $155,000 in additional non-interest income when
comparing the nine-month periods and helped offset the impact of Regulation E
changes on service charge income which declined $85,000 over the same time
period. Losses on the sale of other real estate owned and repossessed assets
decreased $111,000 when comparing the nine-month periods.


- 32
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





RESULTS
OF OPERATIONS – OVERVIEW (Continued)





Total
non-interest expense was $4,478,000 for the third quarter of 2010, an increase
of $552,000 compared with the third quarter of 2009. Salary and benefit expense
increased $294,000 and was the largest contributing factor to the increase in
non-interest expense. This increase is primarily attributable to $130,000 of
severance related expenses for two former officers of the Bank and an incentive
compensation accrual of $109,000. Net occupancy expenses increased $62,000, or
19.1%, when comparing the third quarter of 2010 to 2009. The majority of the
increase relates to lease expense for the land where the permanent Wescosville
branch was built. This branch opened in October 2010. Marketing expense
increased $30,000 primarily related to several large community event
sponsorships. Increases in accounting and auditing, consulting and third-party
information technology services were the primary contributors to the $45,000
increase related to third-party services. FDIC insurance premium expense
increased $33,000, to $268,000, comparing the third quarter of 2010 to 2009.
Significant growth in deposits combined with a slightly higher assessment rate
were the underlying factors in the increase in the premiums.





Total
non-interest expense was $12,837,000 for the nine month period ended September
30, 2010. This represents an increase of $598,000 from the same period in 2009.
Contributing to the variance was an increase in salary and employee benefit
expense of $442,000 resulting from both merit increases and the items noted
above. In addition, higher net occupancy costs of $103,000 and higher
third-party service costs of $111,000 were partially offset by lower FDIC
premiums of $188,000. The higher FDIC expense in 2009 was a result of a special
assessment levied on all insured institutions by the FDIC during the second
quarter of 2009. The special assessment contributed $332,000 of the total
premium in 2009. As noted above significant growth in deposits offset some of
the impact of not having a special assessment in 2010. Also contributing to the
increase in non-interest expense were higher costs related to loan collection,
foreclosure and repossession.





These
items noted in the foregoing overview, as well as others, will be discussed and
analyzed more thoroughly in the next sections.


- 33
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





Average
Balances, Rate, and Interest Income and Expense Summary (Tax-Equivalent
Basis)





Three Months Ended
                                                                                                                    
                                                                                                                    September 30, 2010
                                                                                                                    
                                                                                                                    
                                                                                                                    September 30, 2009Average
                                                                                                                    
                                                                                                                    
                                                                                                                    Average
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    Average
                                                                                                                    
                                                                                                                    
                                                                                                                    AverageBalance
                                                                                                                    
                                                                                                                    
                                                                                                                    Rate
                                                                                                                    
                                                                                                                    
                                                                                                                    Interest
                                                                                                                    
                                                                                                                    
                                                                                                                    Balance
                                                                                                                    
                                                                                                                    
                                                                                                                    Rate
                                                                                                                    
                                                                                                                    
                                                                                                                    InterestAssetsFederal
      funds sold
                                                                                                                    
                                                                                                                    $
                                                                                                                    -
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    -
                                                                                                                    
                                                                                                                    
                                                                                                                    $
                                                                                                                    -
                                                                                                                    
                                                                                                                    
                                                                                                                    $
                                                                                                                    -
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    -
                                                                                                                    
                                                                                                                    
                                                                                                                    $
                                                                                                                    -Investment
      securities:U.S.
      Treasury
                                                                                                                    
                                                                                                                    
                                                                                                                    4,968
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    0.56
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    7
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    5,067
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    1.49
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    19U.S.
      Government agencies
                                                                                                                    
                                                                                                                    
                                                                                                                    51,819
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    2.69
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    349
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    52,686
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    3.67
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    483State
      and municipal
                                                                                                                    
                                                                                                                    
                                                                                                                    60,807
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    6.17
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    937
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    53,033
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    6.53
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    866Mortgage-backed
      and CMOs
                                                                                                                    
                                                                                                                    
                                                                                                                    137,150
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    3.65
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    1,251
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    129,780
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    4.70
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    1,525Other
      debt securities
                                                                                                                    
                                                                                                                    
                                                                                                                    4,290
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    1.45
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    16
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    5,577
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    -4.78
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    (67
                                                                                                                    )Money
      market mutual funds
                                                                                                                    
                                                                                                                    
                                                                                                                    -
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    -
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    -
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    3,174
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    0.40
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    3Equities
                                                                                                                    
                                                                                                                    
                                                                                                                    3,126
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    3.21
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    25
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    3,115
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    3.15
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    25Total
      investment securities
                                                                                                                    
                                                                                                                    
                                                                                                                    262,160
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    3.94
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    2,585
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    252,432
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    4.52
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    2,854Loans:Commercial
      real estate
                                                                                                                    
                                                                                                                    
                                                                                                                    257,567
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    5.95
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    3,861
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    229,153
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    6.14
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    3,546Residential
      real estate
                                                                                                                    
                                                                                                                    
                                                                                                                    24,293
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    5.87
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    356
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    25,447
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    5.96
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    379Home
      equity loans
                                                                                                                    
                                                                                                                    
                                                                                                                    59,688
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    4.97
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    748
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    63,853
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    5.11
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    822Commercial
      and industrial
                                                                                                                    
                                                                                                                    
                                                                                                                    84,212
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    5.29
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    1,122
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    75,407
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    5.17
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    982Indirect
      lease financing
                                                                                                                    
                                                                                                                    
                                                                                                                    13,851
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    9.18
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    318
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    14,557
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    8.48
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    308Consumer
      loans
                                                                                                                    
                                                                                                                    
                                                                                                                    2,954
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    15.22
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    113
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    3,873
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    11.12
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    108Tax-exempt
      loans
                                                                                                                    
                                                                                                                    
                                                                                                                    32,338
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    6.12
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    499
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    24,636
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    5.92
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    368Total
      loans, net of unearned income*
                                                                                                                    
                                                                                                                    
                                                                                                                    474,903
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    5.86
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    7,017
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    436,926
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    5.91
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    6,513Other
      earning assets
                                                                                                                    
                                                                                                                    
                                                                                                                    17,475
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    0.23
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    10
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    9,932
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    0.20
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    5Total
      earning assets
                                                                                                                    
                                                                                                                    
                                                                                                                    754,538
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    5.05
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    9,612
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    699,290
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    5.32
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    9,372Cash
      and due from banks
                                                                                                                    
                                                                                                                    
                                                                                                                    11,088
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    10,180Allowance
      for loan losses
                                                                                                                    
                                                                                                                    
                                                                                                                    (7,270
                                                                                                                    )
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    (4,774
                                                                                                                    )Other
      assets
                                                                                                                    
                                                                                                                    
                                                                                                                    26,144
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    22,456Total
      assets
                                                                                                                    
                                                                                                                    $
                                                                                                                    784,500
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    $
                                                                                                                    727,152Liabilities
      and Shareholders' EquityInterest-bearing
      deposits:Interest-bearing
      demand
                                                                                                                    
                                                                                                                    $
                                                                                                                    82,981
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    0.66
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    138
                                                                                                                    
                                                                                                                    
                                                                                                                    $
                                                                                                                    70,581
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    0.59
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    105Municipals
                                                                                                                    
                                                                                                                    
                                                                                                                    43,436
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    0.94
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    104
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    39,177
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    1.06
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    105Money
      market
                                                                                                                    
                                                                                                                    
                                                                                                                    73,021
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    0.70
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    128
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    66,267
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    1.10
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    184Savings
                                                                                                                    
                                                                                                                    
                                                                                                                    99,376
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    0.79
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    197
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    51,375
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    0.34
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    44Time
                                                                                                                    
                                                                                                                    
                                                                                                                    209,417
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    1.96
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    1,033
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    218,934
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    3.05
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    1,684Time
      of $100,000 or more
                                                                                                                    
                                                                                                                    
                                                                                                                    104,930
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    2.07
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    548
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    108,730
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    3.11
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    851Total
      interest-bearing deposits
                                                                                                                    
                                                                                                                    
                                                                                                                    613,161
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    1.39
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    2,148
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    555,064
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    2.13
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    2,973Short-term
      borrowings
                                                                                                                    
                                                                                                                    
                                                                                                                    32,950
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    1.01
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    84
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    23,063
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    1.10
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    64Long-term
      debt
                                                                                                                    
                                                                                                                    
                                                                                                                    20,105
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    4.75
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    244
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    35,000
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    4.27
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    382Total
      interest-bearing liabilities
                                                                                                                    
                                                                                                                    
                                                                                                                    666,216
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    1.47
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    2,476
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    613,127
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    2.21
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    3,419Non-interest-bearing
      deposits
                                                                                                                    
                                                                                                                    
                                                                                                                    56,595
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    53,596Other
      liabilities
                                                                                                                    
                                                                                                                    
                                                                                                                    3,362
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    5,399Shareholders'
      equity
                                                                                                                    
                                                                                                                    
                                                                                                                    58,327
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    55,030Total
      liabilities andshareholders'
      equity
                                                                                                                    
                                                                                                                    $
                                                                                                                    784,500
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    $
                                                                                                                    727,152Net
      interest rate spread
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    3.58
                                                                                                                    %
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    3.11
                                                                                                                    %Margin/net
      interest income
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    3.75
                                                                                                                    %
                                                                                                                    
                                                                                                                    $
                                                                                                                    7,136
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    3.38
                                                                                                                    %
                                                                                                                    
                                                                                                                    $
                                                                                                                    5,953





Tax-exempt
securities and loans were adjusted to a tax-equivalent basis and are based on
the marginal Federal corporate tax rate of 34 percent.


Non-accrual
loans and investment securities are included in earning assets.


*
Includes loans held-for-sale


- 34
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





Average
Balances, Rate, and Interest Income and Expense Summary (Tax-Equivalent
Basis)





Nine Months Ended
                                                                                                                        
                                                                                                                        September 30, 2010
                                                                                                                        
                                                                                                                        
                                                                                                                        September 30, 2009Average
                                                                                                                        
                                                                                                                        
                                                                                                                        Average
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        Average
                                                                                                                        
                                                                                                                        
                                                                                                                        AverageBalance
                                                                                                                        
                                                                                                                        
                                                                                                                        Rate
                                                                                                                        
                                                                                                                        
                                                                                                                        Interest
                                                                                                                        
                                                                                                                        
                                                                                                                        Balance
                                                                                                                        
                                                                                                                        
                                                                                                                        Rate
                                                                                                                        
                                                                                                                        
                                                                                                                        InterestAssetsFederal
      funds sold
                                                                                                                        
                                                                                                                        $
                                                                                                                        -
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        -
                                                                                                                        
                                                                                                                        
                                                                                                                        $
                                                                                                                        -
                                                                                                                        
                                                                                                                        
                                                                                                                        $
                                                                                                                        1,326
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        0.15
                                                                                                                        %
                                                                                                                        
                                                                                                                        $
                                                                                                                        2Investment
      securities:U.S.
      Treasury
                                                                                                                        
                                                                                                                        
                                                                                                                        5,001
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        0.57
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        21
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        5,057
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        1.56
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        59U.S.
      Government agencies
                                                                                                                        
                                                                                                                        
                                                                                                                        56,431
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        3.14
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        1,329
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        45,138
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        4.20
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        1,421State
      and municipal
                                                                                                                        
                                                                                                                        
                                                                                                                        57,942
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        6.26
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        2,718
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        49,795
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        6.53
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        2,439Mortgage-backed
      and CMOs
                                                                                                                        
                                                                                                                        
                                                                                                                        130,901
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        3.95
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        3,880
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        125,789
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        5.02
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        4,734Other
      debt securities
                                                                                                                        
                                                                                                                        
                                                                                                                        4,388
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        1.27
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        42
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        6,203
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        1.47
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        68Money
      market mutual funds
                                                                                                                        
                                                                                                                        
                                                                                                                        -
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        -
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        -
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        4,628
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        0.68
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        23Equities
                                                                                                                        
                                                                                                                        
                                                                                                                        2,981
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        3.57
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        80
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        3,245
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        3.14
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        76Total
      investment securities
                                                                                                                        
                                                                                                                        
                                                                                                                        257,644
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        4.18
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        8,070
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        239,855
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        4.90
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        8,820Loans:Commercial
      real estate
                                                                                                                        
                                                                                                                        
                                                                                                                        249,497
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        5.95
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        11,108
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        216,054
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        6.19
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        9,996Residential
      real estate
                                                                                                                        
                                                                                                                        
                                                                                                                        24,534
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        5.80
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        1,067
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        24,795
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        5.97
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        1,110Home
      equity loans
                                                                                                                        
                                                                                                                        
                                                                                                                        60,610
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        5.06
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        2,295
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        65,500
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        5.16
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        2,527Commercial
      and industrial
                                                                                                                        
                                                                                                                        
                                                                                                                        82,039
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        5.23
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        3,211
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        73,887
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        5.07
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        2,804Indirect
      lease financing
                                                                                                                        
                                                                                                                        
                                                                                                                        13,916
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        8.92
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        931
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        14,811
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        8.65
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        961Consumer
      loans
                                                                                                                        
                                                                                                                        
                                                                                                                        3,272
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        13.74
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        336
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        4,030
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        10.52
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        317Tax-exempt
      loans
                                                                                                                        
                                                                                                                        
                                                                                                                        30,242
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        5.98
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        1,353
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        24,934
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        5.98
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        1,114Total
      loans, net of unearned income*
                                                                                                                        
                                                                                                                        
                                                                                                                        464,110
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        5.85
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        20,301
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        424,011
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        5.94
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        18,829Other
      earning assets
                                                                                                                        
                                                                                                                        
                                                                                                                        16,874
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        0.23
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        29
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        6,013
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        0.17
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        8Total
      earning assets
                                                                                                                        
                                                                                                                        
                                                                                                                        738,628
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        5.14
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        28,400
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        671,205
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        5.51
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        27,659Cash
      and due from banks
                                                                                                                        
                                                                                                                        
                                                                                                                        10,108
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        9,813Allowance
      for loan losses
                                                                                                                        
                                                                                                                        
                                                                                                                        (6,743
                                                                                                                        )
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        (4,364
                                                                                                                        )Other
      assets
                                                                                                                        
                                                                                                                        
                                                                                                                        25,997
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        22,189Total
      assets
                                                                                                                        
                                                                                                                        $
                                                                                                                        767,990
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        $
                                                                                                                        698,843Liabilities
      and Shareholders' EquityInterest-bearing
      deposits:Interest-bearing
      demand
                                                                                                                        
                                                                                                                        $
                                                                                                                        83,576
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        0.68
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        428
                                                                                                                        
                                                                                                                        
                                                                                                                        $
                                                                                                                        68,346
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        0.53
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        273Municipals
                                                                                                                        
                                                                                                                        
                                                                                                                        37,186
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        1.01
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        281
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        31,236
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        1.13
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        264Money
      market
                                                                                                                        
                                                                                                                        
                                                                                                                        74,270
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        0.82
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        455
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        57,132
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        1.23
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        525Savings
                                                                                                                        
                                                                                                                        
                                                                                                                        87,792
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        0.79
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        518
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        48,502
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        0.28
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        103Time
                                                                                                                        
                                                                                                                        
                                                                                                                        213,159
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        2.15
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        3,427
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        218,718
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        3.27
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        5,352Time
      of $100,000 or more
                                                                                                                        
                                                                                                                        
                                                                                                                        105,780
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        2.24
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        1,771
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        107,700
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        3.33
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        2,681Total
      interest-bearing deposits
                                                                                                                        
                                                                                                                        
                                                                                                                        601,763
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        1.53
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        6,880
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        531,634
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        2.31
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        9,198Short-term
      borrowings
                                                                                                                        
                                                                                                                        
                                                                                                                        27,319
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        1.00
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        204
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        19,615
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        1.18
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        173Long-term
      debt
                                                                                                                        
                                                                                                                        
                                                                                                                        22,673
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        4.71
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        810
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        35,000
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        4.26
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        1,132Total
      interest-bearing liabilities
                                                                                                                        
                                                                                                                        
                                                                                                                        651,755
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        1.62
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        7,894
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        586,249
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        2.40
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        10,503Non-interest-bearing
      deposits
                                                                                                                        
                                                                                                                        
                                                                                                                        55,874
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        53,109Other
      liabilities
                                                                                                                        
                                                                                                                        
                                                                                                                        3,395
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        4,858Shareholders'
      equity
                                                                                                                        
                                                                                                                        
                                                                                                                        56,966
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        54,627Total
      liabilities and shareholders' equity
                                                                                                                        
                                                                                                                        $
                                                                                                                        767,990
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        $
                                                                                                                        698,843Net
      interest rate spread
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        3.52
                                                                                                                        %
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        3.11
                                                                                                                        %Margin/net
      interest income
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        3.71
                                                                                                                        %
                                                                                                                        
                                                                                                                        $
                                                                                                                        20,506
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        3.42
                                                                                                                        %
                                                                                                                        
                                                                                                                        $
                                                                                                                        17,156





Tax-exempt
securities and loans were adjusted to a tax-equivalent basis and are based on
the marginal Federal corporate tax rate of 34 percent.


Non-accrual
loans are included in earning assets.


*
Includes loans held-for-sale


- 35
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





Rate/Volume Analysis. The
following table shows the fully taxable equivalent effect of changes in volumes
and rates on interest income and interest expense. Changes in net interest
income that could not be specifically identified as either a rate or volume
change were allocated to changes in volume.





Three Months Ended
                
                
                Nine Months EndedSeptember 30, 2010 compared
                
                
                September 30, 2010 comparedto September 30, 2009
                
                
                to September 30, 2009Total
                
                
                Due to change in:
                
                
                Total
                
                
                Due to change in:Change
                
                
                Volume
                
                
                Rate
                
                
                Change
                
                
                Volume
                
                
                RateInterest
      income:Federal
      funds sold
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                (2
                )
                
                $
                (2
                )
                
                $
                -Investment
      securities:U.S.
      Treasury
                
                
                (12
                )
                
                
                -
                
                
                
                (12
                )
                
                
                (38
                )
                
                
                (1
                )
                
                
                (37
                )U.S.
      Government agencies
                
                
                (134
                )
                
                
                (8
                )
                
                
                (126
                )
                
                
                (92
                )
                
                
                355
                
                
                
                (447
                )State
      and municipal
                
                
                71
                
                
                
                127
                
                
                
                (56
                )
                
                
                279
                
                
                
                398
                
                
                
                (119
                )Mortgage-backed
      and CMOs
                
                
                (274
                )
                
                
                86
                
                
                
                (360
                )
                
                
                (854
                )
                
                
                193
                
                
                
                (1,047
                )Other
      debt securities
                
                
                83
                
                
                
                16
                
                
                
                67
                
                
                
                (26
                )
                
                
                (20
                )
                
                
                (6
                )Money
      market mutual funds
                
                
                (3
                )
                
                
                (3
                )
                
                
                -
                
                
                
                (23
                )
                
                
                (23
                )
                
                
                -Equities
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                4
                
                
                
                (6
                )
                
                
                10Loans:Commercial
      real estate
                
                
                315
                
                
                
                439
                
                
                
                (124
                )
                
                
                1,112
                
                
                
                1,546
                
                
                
                (434
                )Residential
      real estate
                
                
                (23
                )
                
                
                (17
                )
                
                
                (6
                )
                
                
                (43
                )
                
                
                (11
                )
                
                
                (32
                )Home
      equity loans
                
                
                (74
                )
                
                
                (53
                )
                
                
                (21
                )
                
                
                (232
                )
                
                
                (188
                )
                
                
                (44
                )Commercial
      and industrial
                
                
                140
                
                
                
                115
                
                
                
                25
                
                
                
                407
                
                
                
                309
                
                
                
                98Indirect
      lease financing
                
                
                10
                
                
                
                (14
                )
                
                
                24
                
                
                
                (30
                )
                
                
                (58
                )
                
                
                28Consumer
      loans
                
                
                5
                
                
                
                (26
                )
                
                
                31
                
                
                
                19
                
                
                
                (60
                )
                
                
                79Tax-exempt
      loans
                
                
                131
                
                
                
                115
                
                
                
                16
                
                
                
                239
                
                
                
                238
                
                
                
                1Other
      earning assets
                
                
                5
                
                
                
                4
                
                
                
                1
                
                
                
                21
                
                
                
                14
                
                
                
                7Total
      interest income
                
                
                240
                
                
                
                781
                
                
                
                (541
                )
                
                
                741
                
                
                
                2,684
                
                
                
                (1,943
                )Interest
      expense:Interest-bearing
      demand
                
                
                33
                
                
                
                18
                
                
                
                15
                
                
                
                155
                
                
                
                62
                
                
                
                93Municipals
                
                
                (1
                )
                
                
                12
                
                
                
                (13
                )
                
                
                17
                
                
                
                50
                
                
                
                (33
                )Money
      market
                
                
                (56
                )
                
                
                18
                
                
                
                (74
                )
                
                
                (70
                )
                
                
                157
                
                
                
                (227
                )Savings
                
                
                153
                
                
                
                41
                
                
                
                112
                
                
                
                415
                
                
                
                83
                
                
                
                332Time
                
                
                (651
                )
                
                
                (73
                )
                
                
                (578
                )
                
                
                (1,925
                )
                
                
                (135
                )
                
                
                (1,790
                )Time
      of $100,000 or more
                
                
                (303
                )
                
                
                (29
                )
                
                
                (274
                )
                
                
                (910
                )
                
                
                (48
                )
                
                
                (862
                )Short-term
      borrowings
                
                
                20
                
                
                
                28
                
                
                
                (8
                )
                
                
                31
                
                
                
                69
                
                
                
                (38
                )Long-term
      debt
                
                
                (138
                )
                
                
                (163
                )
                
                
                25
                
                
                
                (322
                )
                
                
                (399
                )
                
                
                77Total
      interest expense
                
                
                (943
                )
                
                
                (148
                )
                
                
                (795
                )
                
                
                (2,609
                )
                
                
                (161
                )
                
                
                (2,448
                )Net
      interest income
                
                $
                1,183
                
                
                $
                929
                
                
                $
                254
                
                
                $
                3,350
                
                
                $
                2,845
                
                
                $
                505


- 36
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





NET
INTEREST INCOME





The
following table presents the adjustment to convert net interest income to net
interest income on a fully taxable-equivalent basis for the three and nine-month
periods ended September 30, 2010 and 2009.





For the Three Months
                      
                      
                      For the Nine MonthsEnded September 30,
                      
                      
                      Ended September 30,2010
                      
                      
                      2009
                      
                      
                      2010
                      
                      
                      2009Total
      interest income
                      
                      $
                      9,117
                      
                      
                      $
                      8,946
                      
                      
                      $
                      26,994
                      
                      
                      $
                      26,431Total
      interest expense
                      
                      
                      2,476
                      
                      
                      
                      3,419
                      
                      
                      
                      7,894
                      
                      
                      
                      10,503Net
      interest income
                      
                      
                      6,641
                      
                      
                      
                      5,527
                      
                      
                      
                      19,100
                      
                      
                      
                      15,928Tax-equivalent
      adjustment
                      
                      
                      495
                      
                      
                      
                      426
                      
                      
                      
                      1,406
                      
                      
                      
                      1,228Net
      interest income (fully taxable-equivalent)
                      
                      $
                      7,136
                      
                      
                      $
                      5,953
                      
                      
                      $
                      20,506
                      
                      
                      $
                      17,156





Net
interest income is the primary source of operating income for QNB. Net interest
income is interest income, dividends, and fees on earning assets, less interest
expense incurred for funding sources. Earning assets primarily include loans,
investment securities, interest bearing balances at the Federal Reserve Bank
(Fed) and Federal funds sold. Sources used to fund these assets include deposits
and borrowed funds. Net interest income is affected by changes in interest
rates, the volume and mix of earning assets and interest-bearing liabilities,
and the amount of earning assets funded by non-interest bearing
deposits.





For
purposes of this discussion, interest income and the average yield earned on
loans and investment securities are adjusted to a tax-equivalent basis as
detailed in the tables that appear on pages 35 through 36. This adjustment to
interest income is made for analysis purposes only. Interest income is increased
by the amount of savings of Federal income taxes, which QNB realizes by
investing in certain tax-exempt state and municipal securities and by making
loans to certain tax-exempt organizations. In this way, the ultimate economic
impact of earnings from various assets can be more easily compared.





The net
interest rate spread is the difference between average rates received on earning
assets and average rates paid on interest-bearing liabilities, while the net
interest rate margin, which includes interest-free sources of funds, is net
interest income expressed as a percentage of average interest-earning
assets.





Quarter
to Quarter Comparison





Net
interest income increased $1,114,000, or 20.2%, to $6,641,000 for the third
quarter of 2010 compared to the third quarter of 2009. Net interest income for
the third quarter of 2010 also reflects an improvement of $206,000, or 3.2% when
compared with the second quarter of 2010 and $617,000, or 10.2% when compared to
the first quarter of 2010. On a tax-equivalent basis, net interest income
increased $1,183,000, or 19.9%, from $5,953,000 for the three months ended
September 30, 2009 to $7,136,000 for the same period ended September 30,
2010.





Several
factors contributed to the significant increase in net interest income. Strong
growth in deposits and the deployment of these deposits into commercial loans
contributed to the growth in tax-equivalent interest income of $240,000, or
2.6%. Total average deposits increased $61,096,000, or 10.0%, to $669,756,000
when comparing the three months ended September 30, 2010 and September 30, 2009.
Over this same time period total average loans increased $37,977,000, or 8.7%,
and total average investment securities increased $9,728,000, or 3.9%. An even
more significant factor in the increase in net interest income was the decrease
in interest expense resulting from a change in the mix of deposit types, the
pricing of new and reinvested time deposits and money market accounts at lower
market rates and a reduction in higher cost long-term debt. Interest expense
declined by $943,000, or 27.6%, when comparing the two quarters. As a result of
these factors the net interest margin improved to 3.75% for the third quarter of
2010 compared to 3.38% for the third quarter of 2009.


- 37
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





NET
INTEREST INCOME (Continued)





While the
economy has shown signs of improvement, issues in the residential and commercial
real estate markets persist as do high levels of unemployment and extremely low
levels of inflation. As a result of these factors, as well as actions by the
Federal Reserve, both actual and anticipated, interest rates on Treasury
securities declined further during the third quarter of 2010 and are at
historically low levels. These low levels of interest rates have been in place
since 2008 and have resulted in lower yields earned on both loans and investment
securities as well as lower rates paid on deposits and borrowed
funds.





The yield
on earning assets on a tax-equivalent basis decreased 27 basis points from 5.32%
for the third quarter of 2009 to 5.05% for the third quarter of 2010. The yield
of 5.05% for the third quarter of 2010 represents a decrease of 11 basis points
from the 5.16% reported for the second quarter of 2010. The yield on earning
assets has held up fairly well as a result of the ability to grow loans at
reasonable returns. This has been able to somewhat offset the decline in the
yield on the investment portfolio which has seen a significant amount of higher
yielding securities get called or prepaid and reinvested at much lower
rates.





In
comparison, the rate paid on interest-bearing liabilities decreased 74 basis
points from 2.21% for the third quarter of 2009 to 1.47% for the third quarter
of 2010 and decreased 14 basis points when compared to 1.61% reported in the
second quarter of 2010.





Interest
income on investment securities decreased $269,000 when comparing the two
quarters as the increase in average balances could only partially offset the 58
basis point decline in the average yield of the portfolio. The average yield on
the investment portfolio was 3.94% for the third quarter of 2010 compared with
4.52% for the third quarter of 2009. Impacting interest income and the yield on
the investment portfolio in 2009 was the reversal of $100,000 in interest on
trust preferred securities placed on nonaccrual. Excluding this reversal the
yield on the portfolio would have been 4.68% for the third quarter of 2009. As
noted above, the decline in the yield on the investment portfolio is primarily
the result of the extended period of low interest rates which has resulted in an
increase in cash flow from the investment portfolio as prepayments speeds on
mortgage-backed securities and CMOs ramped-up as did the amount of calls of
agency and municipal securities. The reinvestment of these funds were generally
in securities that had lower yields than what they replaced. The growth in the
investment portfolio was primarily in high quality U.S. Government agency issued
mortgage-backed and CMO securities as well as in tax-exempt State and municipal
bonds. Income on Government agency securities decreased $134,000, as the yield
declined 98 basis points from 3.67% for third quarter of 2009 to 2.69% for the
same period in 2010. Most of the bonds in the agency portfolio have call
features ranging from three months to five years, many of which were exercised
as a result of the low interest rate environment. The proceeds from these called
bonds were reinvested in securities with significantly lower yields. Interest
income on mortgage-backed securities and CMOs decreased $274,000 with lower
yields being the primary factor. The yield on the mortgage-backed portfolio
decreased 105 basis points from 4.70% to 3.65% when comparing the third quarter
of 2009 and 2010. This was partially offset by the 5.7% increase in average
balances. Interest on tax-exempt municipal securities increased $71,000 with
higher balances accounting for $127,000 of additional income. Municipal bonds
yields did not decline to the same degree as yields on other types of
securities. As a result QNB expanded its purchase of municipal bonds, with
average balances increasing $7,774,000 or 14.7% to $60,807,000 for the third
quarter of 2010. The yield on the state and municipal portfolio decreased from
6.53% for the third quarter of 2009 to 6.17% for the third quarter of
2010.





The other
debt securities portfolio is currently comprised primarily of pooled trust
preferred securities, most of which are on nonaccrual status. As mentioned
earlier, $100,000 of interest on these securities was reversed when they were
placed on nonaccrual in the third quarter of 2009. This resulted in negative
interest income of $67,000 for the third quarter of 2009 compared with $16,000
in the third quarter of 2010.





To reduce
credit risk in the portfolio QNB has proactively sold over the past two years
corporate bonds issued by financial institutions, nonagency issued CMOs and
noninvestment grade and nonrated state and municipal bonds. These sales
generally resulted in the recording of gains but usually also resulted in the
selling of some higher yielding bonds.


- 38
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





NET
INTEREST INCOME (Continued)





With the
issues in the economy and indications that the Federal Reserve Open Market
Committee will continue to keep its target rate at between 0.0% and 0.25% for an
extended period of time and will begin a second round of treasury purchases
known as quantitative easing, treasury yields have fallen even further with the
10 year rate declining below 2.5%. When combined with spread tightening on
agency bonds, mortgage securities and municipal securities, yields on investment
securities are anemic. As a result the yield on the total investment portfolio
is anticipated to continue to decline as cash flow from the portfolio, as well
as excess liquidity, is reinvested at current market rates which are
significantly below the projected portfolio yield at September 30, 2010 of
3.86%.





Income on
loans increased $504,000 to $7,017,000 when comparing the third quarters of 2010
and 2009 as the impact of declining interest rates was offset by the growth in
the portfolio. Average loans increased $37,977,000, or 8.7%, and this volume
increase contributed an additional $559,000 in interest income. The yield on
loans decreased only five basis points, to 5.86% when comparing the same
periods, resulting in a reduction in interest income of $55,000. The yield on
loans increased by two basis points when comparing the third quarter of 2010 to
the second quarter of 2010. Reducing the impact of the decline in interest rates
on loan yields is the structure of the loan portfolio, which has a significant
portion of fixed-rate and adjustable-rate loans with fixed-rate terms for three
to ten years. Also helping to stabilize the yield was the implementation of
interest rate floors on some variable rate commercial loans and home equity
lines of credit. The rate earned on loans has not fallen to the degree that the
rate earned on investment securities, which are more closely tied to the
treasury yield curve.





Most of
the growth in the loan portfolio, both in terms of balances and interest income,
was in the category of commercial real estate loans. This category of loans
includes commercial purpose loans secured by either commercial properties such
as office buildings, factories, warehouses, medical facilities and retail
establishments, or residential real estate, usually the residence of the
business owner. The category also includes construction and land development
loans. Income on these loans increased $315,000, with average balances
increasing $28,414,000, or 12.4%, to $257,567,000, for the three months ended
September 30, 2010. The yield on commercial real estate loans was 5.95% for the
third quarter of 2010, a decline of 19 basis points from the 6.14% reported for
the third quarter of 2009. Interest on commercial and industrial loans, the
second largest category, increased $140,000 with a positive impact from both the
growth in balances and the increase in the yield. Average commercial and
industrial loans increased $8,805,000, or 11.7%, to $84,212,000 for the third
quarter of 2010, contributing an additional $115,000 in interest income. The
average yield on these loans increased 12 basis points to 5.29% resulting in an
increase in income of $25,000. The implementation of interest rate floors on
loans in this category, primarily lines of credit indexed to the prime rate, was
a major factor in the improvement in the yield.





Another
strong growth area has been loans to tax-exempt municipalities and
organizations. This category of loans increased $7,702,000, or 31.3% when
comparing the averages for the three months ended September 30, 2010 and 2009.
This growth in balances along with an increase in the yield on the portfolio
from 5.92% for the third quarter of 2009 to 6.12% for the third quarter of 2010
resulted in an increase in interest income of $131,000.





Income on
home equity loans declined by $74,000 when comparing the third quarter of 2010
and 2009. Over this same time period average home equity loans decreased
$4,165,000, or 6.5%, to $59,688,000, while the yield on the home equity
portfolio decreased 14 basis points to 4.97%. The demand for home equity loans
has declined as home values have fallen preventing some homeowners from having
equity in their homes to borrow against while others have taken advantage of the
low interest rates on mortgages and refinanced their home equity loans into a
new mortgage. Included in the home equity portfolio are floating rate home
equity lines tied to the prime lending rate. The average balance of these loans
increased by $2,488,000, or 10.9%, to $25,348,000 for the third quarter of 2010.
In contrast, average fixed rate home equity loans declined by $6,653,000, or
16.2%, to $34,340,000. Customers who are opening home equity loans are choosing
the floating rate option indexed to prime even with a rate floor because the
rate is currently significantly lower than a fixed rate home equity loan. In an
attempt to boost demand, QNB has been offering an attractive fixed rate home
equity loan promotion. This promotion which began during the second quarter of
2010 has had limited success, an indication of lack of demand by
consumers.


- 39
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QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





NET
INTEREST INCOME (Continued)





Income on
other earning assets is comprised of interest on deposits in correspondent
banks, primarily the Federal Reserve Bank and dividends on restricted
investments in bank stocks, primarily the Federal Home Loan Bank of Pittsburgh
(FHLB). Income on other earning assets increased from $5,000 for the third
quarter of 2009 to $10,000 for the third quarter of 2010. Beginning in December
2008, the Fed began paying 0.25% on balances in excess of required reserves.
With this rate being above what could be earned on selling Federal funds or
investing in AAA rated money market mutual funds excess liquidity was housed at
the Fed. The average balance held at the Federal Reserve Bank was $15,157,000
for the three months ended September 30, 2010 compared with $7,520,000 for the
third quarter of 2009. In December 2008, the FHLB notified member banks that it
was suspending dividend payments to preserve capital. There was no dividend
income from the FHLB in either the third quarter of 2010 or 2009.





For the
most part, earning assets are funded by deposits, which increased on average by
$61,096,000, or 10.0%, to $669,756,000, when comparing the third quarters of
2010 and 2009. It appears that customers continue to seek the safety of FDIC
insured deposits and the stability of a strong local community bank as opposed
to the volatility of the equity markets and the uncertainty of the larger
regional and national banks. On October 3, 2008, in response to the ongoing
economic crisis affecting the financial services industry, the Emergency
Economic Stabilization Act of 2008 was enacted which temporarily raised the
basic limit on FDIC coverage from $100,000 to $250,000 per depositor until
December 31, 2009. However, legislation was passed during the second quarter of
2009 that extended the higher coverage through December 31, 2013. The recently
enacted Dodd-Frank Act made the $250,000 coverage permanent. In addition, on
October 13, 2008, the FDIC established a program under which the FDIC will fully
guarantee all non-interest bearing transaction accounts until December 31, 2009
(the “Transaction Account Guarantee Program”). On August 26, 2009 the FDIC
amended the program to extend the date six months until June 30, 2010 to those
institutions that do not opt out of participating. On April 19, 2010 the program
was extended again until December 31, 2010. QNB is participating in the
Transaction Account Guarantee Program. To participate in this program QNB pays a
fee of 15 basis points. These programs likely contributed to the growth in
deposits.





While
total income on earning assets on a tax-equivalent basis increased $240,000 when
comparing the third quarter of 2010 to the third quarter of 2009, total interest
expense declined $943,000. Interest expense on total deposits decreased $825,000
while interest expense on borrowed funds decreased $118,000 when comparing the
two quarters. The rate paid on interest-bearing liabilities decreased 74 basis
points from 2.21% for the third quarter of 2009 to 1.47% for the third quarter
of 2010. During this same period, the rate paid on interest-bearing deposits
also decreased 74 basis points from 2.13% to 1.39%.





All
categories of average deposits, except for time deposits, increased when
comparing the third quarter of 2010 to the same period in 2009. Unlike prior
years the growth was not centered in time deposits but in interest-bearing
demand, money market and savings deposits, accounts with greater liquidity.
Average interest-bearing demand accounts increased $12,400,000, or 17.6%, to
$82,981,000 for the three months ended September 30, 2010 compared to the three
months ended September 30, 2009. It does however represent a slight decrease in
average balances from the $85,940,000 reported in the second quarter of 2010.
Interest expense on interest-bearing demand accounts increased from $105,000 for
the third quarter of 2009 to $138,000 for the third quarter of 2010 while the
average rate paid increased from 0.59% to 0.66%. The increase in the average
rate paid reflects a change in the mix of accounts included in interest-bearing
demand accounts. Included in this category is QNB-Rewards checking, a high rate
checking account. For the third quarter of 2009 the product paid a yield of
3.25% on balances up to $25,000. This yield was reduced on February 10, 2010 to
2.75% and again on August 18, 2010 to 2.05% In order to receive the high rate a
customer must receive an electronic statement, have one direct deposit or other
ACH transaction and have at least 12 check card purchase transactions post per
statement cycle. For the third quarter of 2010, the average balance in the
product was $27,024,000 and the related interest expense was $131,000 for an
average yield of 1.92%. This lower rate reflects the lower rate paid on accounts
that do not meet the qualifications or on balances in excess of $25,000 which
paid 1.01% until August 18, 2010 and 0.75% after. In comparison the average
balance for the third quarter of 2009 was $15,102,000 with a related interest
expense of $98,000 and an average rate paid of 2.56%. Even with the drop in the
rate paid, it is anticipated that this product will continue to result in the
movement of balances from lower yielding deposit accounts to this product, but
will also result in obtaining new customers and additional deposits of existing
customers. This product also generates fee income through the use of the check
card.


- 40
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QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





NET
INTEREST INCOME (Continued)





Average
money market accounts increased $6,754,000, or 10.2%, to $73,021,000 for the
third quarter of 2010 compared with the third quarter of 2009. Despite the
significant increase in balances, interest expense on money market accounts
decreased $56,000 to $128,000 for the third quarter of 2010 compared to the
third quarter of 2009. The average interest rate paid on money market accounts
was 1.10% for the third quarter of 2009 and 0.70% for the third quarter of 2010,
a decline of 40 basis points. Included in total money market balances is the
Select money market account, a higher yielding money market product that pays a
tiered rate based on account balances. With the sharp decline in short-term
interest rates, the rates paid on the Select money market account have declined
as well.





During
the second quarter of 2009, QNB introduced an online only eSavings account to
compete with other online savings accounts. This product was introduced at a
yield of 1.85% and has been extremely successful having grown to $52,661,000 at
September 30, 2010. The eSavings yield was reduced to 1.60% on March 17, 2010
and to 1.30% on August 6, 2010. The average balance of this product was
$48,355,000 for the third quarter of 2010 compared with $3,083,000 for the third
quarter of 2009 and contributed to the $48,001,000, or 93.4%, increase in total
average savings accounts when comparing the two quarters. Average statement
savings accounts also increased $3,002,000, or 6.4%, when comparing the same
periods. As a result of the eSavings product the average rate paid on savings
accounts increased 45 basis points from 0.34% for the third quarter of 2009 to
0.79% for the third quarter of 2010. The growth in balances appears to reflect
the desire for safety, liquidity and a rate better than short-term time
deposits.





The
repricing of time deposits at lower rates over the past year has had the
greatest impact on total interest expense when comparing the two quarters. Total
interest expense on time deposits decreased $954,000, or 37.6%, to $1,581,000
for the third quarter of 2010. Average total time deposits decreased by
$13,317,000, or 4.1%, to $314,347,000 for the third quarter of 2010. Similar to
fixed-rate loans and investment securities, time deposits reprice over time and,
therefore, have less of an immediate impact on costs in either a rising or
falling rate environment. Unlike loans and investment securities, however, the
maturity and repricing characteristics of time deposits tend to be shorter. Over
the course of 2009 and the first nine months of 2010 a significant amount of
time deposits have repriced lower as rates have declined. The average rate paid
on time deposits decreased from 3.07% to 1.99% when comparing the third quarter
of 2009 to the same period in 2010.





Approximately
$223,918,000, or 71.9%, of time deposits at September 30, 2010 will reprice or
mature over the next 12 months. The average rate paid on these time deposits is
approximately 1.90%. During the fourth quarter of 2010 approximately $35,539,000
of time deposits yielding 1.91% will mature. Given the short-term nature of
QNB’s time deposit portfolio and the current rates being offered, it is likely
that the average rate paid on time deposits should decline slightly through the
remainder of 2010 as higher costing time deposits are repriced
lower.





Short-term
borrowings are primarily comprised of sweep accounts structured as repurchase
agreements with our commercial customers. Interest expense on short-term
borrowings increased by $20,000 to $84,000 when comparing the two quarters.
During this period average balances increased $9,887,000, or 42.9% to
$32,950,000 while the average rate paid declined from 1.10% to
1.01%.





Contributing
to the decrease in total interest expense was a reduction in interest expense on
long-term debt of $138,000. In January 2010, $10,000,000 in FHLB advances at a
rate of 2.97% matured and were repaid. In addition, in April 2010 another
$5,000,000 of debt at a rate of 4.90% matured and was repaid resulting in the
reduction in expense. Since the average rate paid on the debt that was repaid
was lower than the remaining debt the average rate paid increased from 4.27% for
the third quarter of 2009 to 4.75% for the third quarter of
2010.


- 41
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QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





NET
INTEREST INCOME (Continued)





Nine
Month Comparison





For the
nine-month period ended September 30, 2010, tax-equivalent net interest income
increased $3,350,000, or 19.5%. Average earning assets increased $67,423,000, or
10.0%, to $738,628,000 with average loans and investment securities increasing
9.5% and 7.4%, respectively. Average total deposits increased $72,894,000, or
12.5%, to $657,637,000 for the nine month period ended September 30, 2010
compared to the same period in 2009. The net interest margin on a tax-equivalent
basis was 3.71% for the nine-month period ended September 30, 2010 compared with
3.42% for the same period in 2009.





Total
interest income on a tax-equivalent basis increased $741,000, from $27,659,000
to $28,400,000, when comparing the nine-month periods ended September 30, 2009
and September 30, 2010 as the additional interest income generated from the
growth in earning assets offset the impact of declining yields on those assets.
Interest income increased $2,684,000 as a result of volume increases but
declined $1,943,000 as a result of lower yields. Average loans increased
$40,099,000 to $464,110,000, with average commercial real estate loans
increasing $33,443,000, or 15.5%, average commercial and industrial loans
increasing $8,152,000, or 11.0% and average tax-exempt loans increasing
$5,308,000, or 21.3%, when comparing the nine-month periods. As a result of the
efforts of our seasoned lending professionals as well as disruptions in our
local banking markets, QNB has been able to win quality commercial relationships
from our local competitors, even during these difficult economic
times.





Over this
same period average investment securities increased $17,789,000, to $257,644,000
with all of the growth occurring in U.S. Government agency bonds, agency issued
mortgage-backed securities and tax-exempt municipal bonds. The yield on earning
assets decreased from 5.51% to 5.14% for the nine-month periods with the yield
on loans decreasing from 5.94% to 5.85% during this time. The yield on
investments decreased from 4.90% to 4.18% when comparing the nine-month periods.
As discussed previously, the yield earned on loans has held up well during this
period of historically low interest rates. The impact has been more significant
on the investment portfolio as many of the bonds have call features which have
been exercised by the issuers or are subject to prepayments as mortgages are
refinanced thereby creating additional cash flow to reinvest. Since bond yields
primarily move in conjunction with the treasury yield curve these cash flows
have been reinvested in significantly lower yielding securities over the past
year.





Total
interest expense decreased $2,609,000, from $10,503,000 for the nine-month
period ended September 30, 2009 to $7,894,000, for the nine-month period ended
September 30, 2010. Approximately all of the decrease in interest expense was a
result of lower rates paid on deposits, especially time deposits. Interest
expense on interest-bearing deposits declined by $2,318,000 with interest
expense on time deposits declining $2,835,000. The average rate paid on time
deposits decreased 111 basis points to 2.18% from 3.29% when comparing the
nine-month periods ended September 30, 2010 and 2009. The average balance of
total time deposits declined $7,479,000, or 2.3% to $318,939,000 for the nine
months ended September 30, 2010 compared with the similar 2009
period.





While the
average balances on time deposits declined when comparing the nine-month
periods, the average balances of transaction accounts increased significantly as
customers sought the liquidity of these accounts as well as the higher rate
being offered on the QNB-Rewards checking product and the eSavings product.
Interest expense on interest-bearing demand deposits increased $155,000,
resulting from both a $15,230,000, or 22.3%, increase in average balances and a
15 basis point increase in the average rate paid. The interest rate paid on
interest-bearing demand accounts increased from 0.53% for the first nine months
of 2009 to 0.68% for the first nine months of 2010. As mentioned previously the
QNB-Rewards checking account was the primary factor in both the growth in total
interest-bearing demand deposits as well as the increase in the rate paid.
Interest expense on money market accounts declined $70,000, as lower rates paid
more than offset the significant increase in average balances. Average money
market balances increased $17,138,000, or 30.0% while the average rate paid
declined from 1.23% for the first nine months of 2009 to 0.82% for the first
nine months of 2010. Interest expense on savings accounts increased $415,000
when comparing the nine-month periods. Average savings account balances
increased $39,290,000, or 81.0%, to $87,792.000 while the average rate paid
increased from 0.28% to 0.79%. Again, most of the increase in both balances and
rate paid is a result of the eSavings product.


- 42
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QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





NET
INTEREST INCOME (Continued)





Also
contributing to the reduction in interest expense when comparing the nine-month
periods was the repayment of long-term debt as discussed earlier. Interest
expense on long-term debt declined by $322,000 as the average balance declined
from $35,000,000 for the first nine months of 2009 to $22,673,000 for the first
nine-months of 2010.





PROVISION
FOR LOAN LOSSES





The
provision for loan losses represents management's determination of the amount
necessary to be charged to operations to bring the allowance for loan losses to
a level that represents management’s best estimate of the known and inherent
losses in the existing loan portfolio. Actual loan losses, net of recoveries,
serve to reduce the allowance.





Management
believes that it uses the best information available to make determinations
about the adequacy of the allowance and that it has established its existing
allowance for loan losses in accordance with U.S. generally accepted accounting
principles (GAAP). The determination of an appropriate level for the allowance
for loan losses is based upon an analysis of the risks inherent in QNB’s loan
portfolio. Management, in determining the allowance for loan losses, makes
significant estimates and assumptions. Since the allowance for loan losses is
dependent, to a great extent, on conditions that may be beyond QNB’s control, it
is at least reasonably possible that management’s estimates of the allowance for
loan losses and actual results could differ. In addition, various regulatory
agencies, as an integral part of their examination process, periodically review
QNB’s allowance for loan losses. Such agencies may require QNB to recognize
changes to the allowance based on their judgments about information available to
them at the time of their examination.





Management
conducts a quarterly analysis of the appropriateness of the allowance for loan
losses. This analysis considers a number of relevant factors including:
historical loan loss experience, general economic conditions, levels of and
trends in delinquent and non-performing loans, levels of classified loans,
trends in the growth rate of loans and concentrations of credit.





QNB
utilizes a risk weighting system that assigns a risk code to every commercial
loan. This risk weighting system is supplemented with a program that encourages
account officers to identify potentially deteriorating loan situations. The
officer analysis program is used to complement the on-going analysis of the loan
portfolio performed during the loan review function. In addition, QNB has a
committee that meets quarterly to review the appropriateness of the allowance
for loan losses based on the current and projected status of all relevant
factors pertaining to the loan portfolio.





As a
result of loan growth, higher than normal levels of net charge-offs, increases
in non-performing, delinquent and classified loans and continued concerns over
current economic conditions, QNB continues to closely monitor the quality of the
loan portfolio and has increased the allowance for loan losses to reflect these
conditions. QNB recorded a provision for loan losses of $1,200,000 in the third
quarter of 2010 and $2,600,000 for the first nine months of 2010. This compares
to a provision of $1,500,000 for the third quarter of 2009 and $2,600,000 for
the first nine months of 2009. The 2010 third quarter provision also represents
an increase of $500,000 from the amount recorded in the second quarter of
2010.





Net loan
charge-offs were $77,000, or 0.07% (annualized) of average total loans for the
third quarter of 2010 compared with $511,000, or 0.47% (annualized) of average
total loans for the third quarter of 2009. Of the charge-offs for the third
quarter of 2009, $460,000 relates to a commercial borrower whose loans were
secured by junior liens on his residence and whose business was negatively
impacted by the downturn in the economy. For the nine month periods ended
September 30, 2010 and 2009 net loan charge-offs were $685,000, or 0.20%
(annualized) and $863,000, or 0.27% (annualized), respectively. Of the
charge-offs for the first nine months of 2010, $350,000 relates to a commercial
borrower whose loan was secured by business assets. Also included in net
charge-offs for the nine month periods ended September 30, 2010 and 2009 were
net charge-offs of $23,000 and $272,000, respectively, of loans in the indirect
lease financing portfolio. This portfolio includes loans to businesses in the
trucking and construction industries which were negatively impacted by the
slowdown in the economy over the past two years. The lower amount of net
charge-offs in the lease portfolio in 2010 reflects recoveries of $197,000
compared with $70,000 in 2009.


- 43
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QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





PROVISION
FOR LOAN LOSSES (Continued)





As
referenced in the following table, the levels of non-performing and delinquent
loans have trended higher over the past year. This is primarily a result of the
difficult economic environment over the past two years and reflects
deterioration in the financial performance of some of our commercial customers.
At September 30, 2010, non-performing loans totaled $9,908,000, as compared with
$6,102,000 at December 31, 2009 and $5,199,000 at September 30, 2009. When
compared to total loans, non-performing loans have risen from 1.19% at September
30, 2009 and 1.36% at December 2009 to 2.07% at September 30, 2010. Despite the
increase in non-performing loans over the past year, QNB’s non-performing loans
to total loans ratio continues to compare favorably with the average 2.61% of
total loans for Pennsylvania commercial banks with assets between $500 million
and $1 billion as reported by the FDIC using June 30, 2010 data, the most recent
available.





Delinquent
loans are considered performing loans and exclude non-accrual loans,
restructured loans and loans 90 days or more past due and still accruing
interest (all of which are considered non-performing loans). Total delinquent
loans at September 30, 2010, December 31, 2009 and September 30, 2009 represent
1.20%, 0.89% and 1.19% of total loans, respectively.





QNB’s
allowance for loan losses of $8,132,000 represents 1.70% of total loans at
September 30, 2010 compared to an allowance for loan losses of $6,217,000, or
1.38% of total loans at December 31, 2009 and $5,573,000, or 1.27% at September
30, 2009. The ratio is at a level that QNB management believes is adequate as of
September 30, 2010 based on its analysis of known and inherent losses in the
portfolio.





A loan is
considered impaired, based on current information and events, if it is probable
that QNB will be unable to collect the scheduled payments of principal or
interest when due according to the contractual terms of the loan agreement.
Impaired loans include non-accrual and restructured loans and certain loans
classified as substandard. The measurement of impaired loans is generally based
on the present value of expected future cash flows discounted at the effective
interest rate, except that all collateral-dependent loans are measured for
impairment based on the fair value of the collateral. At September 30, 2010 and
December 31, 2009, the recorded investment in impaired loans totaled $14,198,000
and $5,699,000, respectively, of which $7,597,000 and $4,622,000, respectively,
required no specific allowance for loan losses. The recorded investment in
impaired loans requiring a specific allowance for loan losses was $6,601,000 and
$1,077,000 at September 30, 2010 and December 31, 2009, respectively. At
September 30, 2010 and December 31, 2009 the related allowance for loan losses
associated with these loans was $1,391,000 and $528,000, respectively. Most of
the loans that have been identified as impaired are
collateral-dependent.





The
following table shows asset quality indicators for the periods
presented:





9/30/10
                  
                  
                  6/30/10
                  
                  
                  3/31/10
                  
                  
                  12/31/09
                  
                  
                  9/30/09Non-performing
      loans
                  
                  $
                  9,908
                  
                  
                  $
                  7,748
                  
                  
                  $
                  5,894
                  
                  
                  $
                  6,102
                  
                  
                  $
                  5,199Non-performing
      loans to total loans
                  
                  
                  2.07
                  %
                  
                  
                  1.63
                  %
                  
                  
                  1.29
                  %
                  
                  
                  1.36
                  %
                  
                  
                  1.19
                  %Delinquent
      loans (30-89 days past due), not included above
                  
                  $
                  5,729
                  
                  
                  $
                  4,448
                  
                  
                  $
                  5,677
                  
                  
                  $
                  4,015
                  
                  
                  $
                  5,210Delinquent
      loans to total loans
                  
                  
                  1.20
                  %
                  
                  
                  0.94
                  %
                  
                  
                  1.24
                  %
                  
                  
                  0.89
                  %
                  
                  
                  1.19
                  %Total
      delinquent and non-performing loans
                  
                  $
                  15,637
                  
                  
                  $
                  12,196
                  
                  
                  $
                  11,571
                  
                  
                  $
                  10,117
                  
                  
                  $
                  10,409Total
      delinquent and non-performing loans to total loans
                  
                  
                  3.27
                  %
                  
                  
                  2.57
                  %
                  
                  
                  2.54
                  %
                  
                  
                  2.25
                  %
                  
                  
                  2.38
                  %Non-performing
      assets
                  
                  $
                  11,417
                  
                  
                  $
                  9,327
                  
                  
                  $
                  6,932
                  
                  
                  $
                  7,032
                  
                  
                  $
                  6,285Non-performing
      assets to total assets
                  
                  
                  1.44
                  %
                  
                  
                  1.20
                  %
                  
                  
                  0.90
                  %
                  
                  
                  0.92
                  %
                  
                  
                  0.86
                  %




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QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





PROVISION
FOR LOAN LOSSES (Continued)





The
following table shows detailed information and ratios pertaining to the
Company’s loan and asset quality:





September 30, 2010
                      
                      
                      December 31, 2009Non-accrual
      loans
                      
                      $
                      8,094
                      
                      
                      $
                      3,086Loans
      past due 90 days or more and still accruing interest
                      
                      
                      199
                      
                      
                      
                      759Restructured
      loans, not included above
                      
                      
                      1,615
                      
                      
                      
                      2,257Total
      non-performing loans
                      
                      $
                      9,908
                      
                      
                      $
                      6,102Other
      real estate owned and repossessed assets
                      
                      
                      12
                      
                      
                      
                      67Non-accrual
      pooled trust preferred securities
                      
                      
                      1,497
                      
                      
                      
                      863Total
      non-performing assets
                      
                      $
                      11,417
                      
                      
                      $
                      7,032Average
      total loans (YTD average)
                      
                      $
                      464,110
                      
                      
                      $
                      427,924Total
      loans, including loans held for sale
                      
                      
                      478,908
                      
                      
                      
                      449,955Allowance
      for loan losses
                      
                      
                      8,132
                      
                      
                      
                      6,217Allowance
      for loan losses to:Non-performing
      loans
                      
                      
                      82.07
                      %
                      
                      
                      101.88
                      %Total
      loans
                      
                      
                      1.70
                      %
                      
                      
                      1.38
                      %Average
      total loans
                      
                      
                      1.75
                      %
                      
                      
                      1.45
                      %Non-performing
      loans / Loans
                      
                      
                      2.07
                      %
                      
                      
                      1.36
                      %Non-performing
      assets / Assets
                      
                      
                      1.44
                      %
                      
                      
                      0.92
                      %





An
analysis of loan charge-offs for the three and nine months ended September 30,
2010 compared to 2009 is as follows:





For the Three Months
                    
                    
                    For the Nine MonthsEnded September 30,
                    
                    
                    Ended September 30,2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009Net
      charge-offs
                    
                    $
                    77
                    
                    
                    $
                    511
                    
                    
                    $
                    685
                    
                    
                    $
                    863Net
      charge-offs (annualized) to:Total
      loans
                    
                    
                    0.06
                    %
                    
                    
                    0.46
                    %
                    
                    
                    0.19
                    %
                    
                    
                    0.26
                    %Average
      total loans
                    
                    
                    0.06
                    %
                    
                    
                    0.46
                    %
                    
                    
                    0.20
                    %
                    
                    
                    0.27
                    %Allowance
      for loan losses
                    
                    
                    3.78
                    %
                    
                    
                    36.45
                    %
                    
                    
                    11.28
                    %
                    
                    
                    20.77
                    %




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QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





NON-INTEREST
INCOME





Non-Interest Income ComparisonThree Months Ended
                                                        
                                                        
                                                        Change from
                                                        
                                                        
                                                        Nine Months Ended
                                                        
                                                        
                                                        Change fromSeptember 30,
                                                        
                                                        
                                                        Prior Year
                                                        
                                                        
                                                        September 30,
                                                        
                                                        
                                                        Prior Year2010
                                                        
                                                        
                                                        2009
                                                        
                                                        
                                                        Amount
                                                        
                                                        
                                                        Percent
                                                        
                                                        
                                                        2010
                                                        
                                                        
                                                        2009
                                                        
                                                        
                                                        Amount
                                                        
                                                        
                                                        PercentNet
      (loss) gain on investmentsecurities
                                                        
                                                        $
                                                        (47
                                                        )
                                                        
                                                        $
                                                        (650
                                                        )
                                                        
                                                        $
                                                        603
                                                        
                                                        
                                                        
                                                        92.8
                                                        %
                                                        
                                                        $
                                                        22
                                                        
                                                        
                                                        $
                                                        (930
                                                        )
                                                        
                                                        $
                                                        952
                                                        
                                                        
                                                        
                                                        102.4
                                                        %Fees
      for services tocustomers
                                                        
                                                        
                                                        392
                                                        
                                                        
                                                        
                                                        470
                                                        
                                                        
                                                        
                                                        (78
                                                        )
                                                        
                                                        
                                                        -16.6
                                                        %
                                                        
                                                        
                                                        1,203
                                                        
                                                        
                                                        
                                                        1,288
                                                        
                                                        
                                                        
                                                        (85
                                                        )
                                                        
                                                        
                                                        -6.6
                                                        %ATM
      and debit card
                                                        
                                                        
                                                        317
                                                        
                                                        
                                                        
                                                        263
                                                        
                                                        
                                                        
                                                        54
                                                        
                                                        
                                                        
                                                        20.5
                                                        %
                                                        
                                                        
                                                        902
                                                        
                                                        
                                                        
                                                        747
                                                        
                                                        
                                                        
                                                        155
                                                        
                                                        
                                                        
                                                        20.7
                                                        %Bank-owned
      life insurance
                                                        
                                                        
                                                        67
                                                        
                                                        
                                                        
                                                        66
                                                        
                                                        
                                                        
                                                        1
                                                        
                                                        
                                                        
                                                        1.5
                                                        %
                                                        
                                                        
                                                        199
                                                        
                                                        
                                                        
                                                        203
                                                        
                                                        
                                                        
                                                        (4
                                                        )
                                                        
                                                        
                                                        -2.0
                                                        %Mortgage
      servicing fees
                                                        
                                                        
                                                        28
                                                        
                                                        
                                                        
                                                        28
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        0.0
                                                        %
                                                        
                                                        
                                                        83
                                                        
                                                        
                                                        
                                                        89
                                                        
                                                        
                                                        
                                                        (6
                                                        )
                                                        
                                                        
                                                        -6.7
                                                        %Net
      gain on sale of loans
                                                        
                                                        
                                                        81
                                                        
                                                        
                                                        
                                                        132
                                                        
                                                        
                                                        
                                                        (51
                                                        )
                                                        
                                                        
                                                        -38.6
                                                        %
                                                        
                                                        
                                                        298
                                                        
                                                        
                                                        
                                                        534
                                                        
                                                        
                                                        
                                                        (236
                                                        )
                                                        
                                                        
                                                        -44.2
                                                        %Other
                                                        
                                                        
                                                        166
                                                        
                                                        
                                                        
                                                        205
                                                        
                                                        
                                                        
                                                        (39
                                                        )
                                                        
                                                        
                                                        -19.0
                                                        %
                                                        
                                                        
                                                        456
                                                        
                                                        
                                                        
                                                        383
                                                        
                                                        
                                                        
                                                        73
                                                        
                                                        
                                                        
                                                        19.1
                                                        %Total
                                                        
                                                        $
                                                        1,004
                                                        
                                                        
                                                        $
                                                        514
                                                        
                                                        
                                                        $
                                                        490
                                                        
                                                        
                                                        
                                                        95.3
                                                        %
                                                        
                                                        $
                                                        3,163
                                                        
                                                        
                                                        $
                                                        2,314
                                                        
                                                        
                                                        $
                                                        849
                                                        
                                                        
                                                        
                                                        36.7
                                                        %





QNB,
through its core banking business, generates various fees and service charges.
Total non-interest income includes service charges on deposit accounts, ATM and
check card income, income on bank-owned life insurance, mortgage servicing fees,
gains and losses on the sale of investment securities and residential mortgage
loans.





Quarter
to Quarter Comparison





Total
non-interest income for the third quarter of 2010 was $1,004,000 compared to
$514,000 for the third quarter of 2009. The primary contributor to the $490,000
increase in non-interest income was a $603,000 reduction in net losses on
investment securities, primarily related to OTTI charges on pooled trust
preferred investment securities, and a $54,000 increase in ATM and debit card
income. Partially offsetting this positive variance was a decrease of $78,000 in
fees for services to customers and a decrease of $51,000 in gains on the sale of
residential mortgages.





The
fixed-income securities portfolio represents a significant portion of QNB’s
earning assets and is also a primary tool in liquidity and asset/liability
management. QNB actively manages its fixed income portfolio in an effort to take
advantage of changes in the shape of the yield curve and changes in spread
relationships in different sectors and for liquidity purposes. Management
continually reviews strategies that will result in an increase in the yield or
improvement in the structure of the investment portfolio.





As noted
previously, activity in the investment securities portfolio contributed $603,000
to the increase in non-interest income. In the third quarter of 2010, there was
a $4,000 gain recognized on the sale of a security which was offset by $51,000
of credit related OTTI charges on a pooled trust preferred security resulting in
a net loss of $47,000 for the 2010 quarter. A description of the valuation
methodology used can be found in Footnotes 7 and 10. In the third quarter of
2009 investment securities activity resulted in a $650,000 net loss and included
$753,000 of credit related OTTI charges in the carrying value of three pooled
trust preferred securities partially offset by $103,000 of gains realized on the
sale of several equity securities.




Fees for
services to customers are primarily comprised of service charges on deposit
accounts. These fees decreased $78,000, to $392,000, when comparing the
three-month periods. Overdraft income decreased $90,000, or 24.6% for the
three-month period, a result of the implementation of new rules under Regulation
E and a reduction in the per item fee charged to customers. In March 2010, QNB
reduced the per item charge for overdrafts by $2, to $35. Offsetting a portion
of the decline in overdraft income was an increase in fees on business checking
accounts of $11,000 for the three-month period. This increase reflects the
impact of a lower earnings credit rate in the third quarter of 2010 as compared
to the second quarter of 2009, resulting from the significant decline in
short-term interest rates. These credits are applied against service charges
incurred to reduce the costs paid by the customer.


- 46
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





NON-INTEREST
INCOME (Continued)





ATM and
debit card income is primarily comprised of transaction income on debit cards
and ATM cards and ATM surcharge income for the use of QNB’s ATM machines by
non-QNB customers. ATM and debit card income was $317,000 for the third quarter
of 2010, an increase of $54,000, or 20.5%, from the amount recorded during the
third quarter of 2009. This primarily reflects growth in ATM and debit card
transactions. Helping to contribute to the growth in debit card transactions is
the growth in the QNB-Rewards checking product, a high-yield checking account
which requires, among other terms, the posting of a minimum of twelve purchase
debit card transactions per statement cycle to receive the high interest
rate.





When QNB
sells its residential mortgages in the secondary market, it retains servicing
rights. A normal servicing fee is retained on all mortgage loans sold and
serviced. QNB recognizes its obligation to service financial assets that are
retained in a transfer of assets in the form of a servicing asset. The servicing
asset is amortized in proportion to, and over, the period of net servicing
income or loss. On a quarterly basis, servicing assets are assessed for
impairment based on their fair value. The timing of mortgage payments and
delinquencies also impacts the amount of servicing fees recorded.





The net
gain on residential mortgage sales is directly related to the volume of
mortgages sold and the timing of the sales relative to the interest rate
environment. Residential mortgage loans to be sold are identified at
origination. The net gain on the sale of residential mortgage loans was $81,000
and $132,000 for the quarters ended September 30, 2010 and 2009, respectively.
This $51,000 decrease in the net gain on sale of loans was a result of decreased
refinancing activity. Many customers who were able to refinance have already
done so due to the low interest rate environment that has existed for the past
two years. Included in the gains on the sale of residential mortgages in these
periods were $12,000 and $37,000, respectively, related to the recognition of
mortgage servicing assets. Proceeds from the sale of residential mortgages were
$1,671,000 and $5,006,000 for the third quarters of 2010 and 2009, respectively.
While the total gains on the sale of mortgages has declined as a result of
reduced volume, the amount of gain recognized on each sale has increased because
of the historically low level of mortgage rates.





Other
income was $166,000 for the third quarter of 2010 and $205,000 for the same
period during 2009. The majority of the difference was attributable to the
following:


·
            Third
      quarter 2009 included $44,000 of income related to an accrual reversal
      that resulted from a Board of Directors’ decision to amend the terms of a
      group term life plan.


·
            Income
      from investment in title insurance company decreased by $19,000 as a
      result of a decline in mortgage
activity.


·
            Merchant
      income increased $7,000, or 10.3%, for the three-month period primarily
      due to new merchant accounts being
obtained.


·
            Losses
      on the sale of repossessed assets and other real estate owned were $11,000
      lower than the third quarter of
2009.





Nine
Month Comparison





Total
non-interest income for the nine-month periods ended September 30, 2010 and 2009
was $3,163,000 and $2,314,000, respectively. Non-interest income for the first
nine months of 2010, excluding net investment securities gains of $22,000,
totaled $3,141,000 compared to $3,244,000 for the first nine months of 2009,
excluding net investment securities losses of $930,000.





Net
securities gains of $22,000 for 2010 include credit related OTTI charges of
$277,000 on three pooled trust preferred securities and net gains of $299,000 on
the sale of investments, primarily equity securities. The net securities losses
of $930,000 for 2009 include OTTI charges of $1,276,000 (a $515,000 charge
related to OTTI in the carrying value of holdings in the equity investment
portfolio and $761,000 of credit related OTTI charges on four of the Company’s
pooled trust preferred securities). These charges were partially offset by net
gains of $346,000 ($210,000 recognized on the sale of equity securities and
gains of $136,000 on the sale of several higher-yielding corporate bonds sold to
reduce credit risk in the portfolio).


- 47
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





NON-INTEREST
INCOME (Continued)





Fees for
services to customers decreased $85,000, or 6.6%, to $1,203,000 for the nine
months ended September 30, 2010. As discussed in the quarterly analysis,
overdraft income declined $120,000 while fees on business checking accounts and
internet banking fees increased $26,000 and $10,000, respectively, when
comparing the nine-month periods.





ATM and
debit card income was $902,000 for the first nine months of 2010, an increase of
$155,000, or 20.7%, from the amount recorded during the first nine months of
2009. ATM interchange income increased $70,000, or 51.2%, to $207,000, a result
of both an increase in the number of transactions and an increase in the amount
QNB receives per transaction. Debit card income increased $102,000 or 19.3% to
$628,000 as the volume of transactions continues to increase as consumers and
businesses increase their usage of the card as a method of paying for goods and
services. The passage of the Dodd-Frank Act could have negative implications on
the amount of interchange income earned by QNB in the future.





For the
nine-month period, gains on the sale of residential mortgages decreased $236,000
to $298,000 as mortgage originations and sales volume decreased. Included in the
gains on the sale of residential mortgages in these periods were $51,000 and
$171,000, respectively, related to the recognition of mortgage servicing assets.
Proceeds from the sale of residential mortgages were $7,057,000 and $22,954,000
for the first nine months of 2010 and 2009, respectively.





Other
income was $456,000 for the first nine months of 2010 and $383,000 for the same
period during 2009. The majority of the difference was caused by the
following:


·
            Losses
      on the sale of other real estate owned and repossessed assets were $6,000
      in 2010 compared to $117,000 during
2009.


·
            Income
      from investment in title insurance company decreased by $34,000 as a
      result of a decline in mortgage activity compared to prior
      year.


·
            Other
      income in 2009 included $44,000 of income related to the reversal of an
      accrual resulting from a Board of Directors decision to amend the terms of
      a group term life plan.


·
            Merchant
      income increased $26,000, or 14.7%, for the nine-month period primarily
      due to new merchant accounts being
obtained.





NON-INTEREST
EXPENSE





Non-InterestExpenseComparisonThree Months Ended
                    
                    
                    Change from
                    
                    
                    Nine Months Ended
                    
                    
                    Change fromSeptember 30,
                    
                    
                    Prior Year
                    
                    
                    September 30,
                    
                    
                    Prior Year2010
                    
                    
                    2009
                    
                    
                    Amount
                    
                    
                    Percent
                    
                    
                    2010
                    
                    
                    2009
                    
                    
                    Amount
                    
                    
                    PercentSalaries
      and employee benefits
                    
                    $
                    2,409
                    
                    
                    $
                    2,115
                    
                    
                    $
                    294
                    
                    
                    
                    13.9
                    %
                    
                    $
                    6,713
                    
                    
                    $
                    6,271
                    
                    
                    $
                    442
                    
                    
                    
                    7.0
                    %Net
      occumpancy
                    
                    
                    386
                    
                    
                    
                    324
                    
                    
                    
                    62
                    
                    
                    
                    19.1
                    %
                    
                    
                    1,115
                    
                    
                    
                    1,012
                    
                    
                    
                    103
                    
                    
                    
                    10.2
                    %Furniture
      and equipment
                    
                    
                    295
                    
                    
                    
                    290
                    
                    
                    
                    5
                    
                    
                    
                    1.7
                    %
                    
                    
                    865
                    
                    
                    
                    895
                    
                    
                    
                    (30
                    )
                    
                    
                    -3.4
                    %Marketing
                    
                    
                    155
                    
                    
                    
                    125
                    
                    
                    
                    30
                    
                    
                    
                    24.0
                    %
                    
                    
                    515
                    
                    
                    
                    489
                    
                    
                    
                    26
                    
                    
                    
                    5.3
                    %Third-party
      services
                    
                    
                    263
                    
                    
                    
                    218
                    
                    
                    
                    45
                    
                    
                    
                    20.6
                    %
                    
                    
                    826
                    
                    
                    
                    715
                    
                    
                    
                    111
                    
                    
                    
                    15.5
                    %Telephone,
      postage and supplies
                    
                    
                    157
                    
                    
                    
                    147
                    
                    
                    
                    10
                    
                    
                    
                    6.8
                    %
                    
                    
                    456
                    
                    
                    
                    452
                    
                    
                    
                    4
                    
                    
                    
                    0.9
                    %State
      taxes
                    
                    
                    143
                    
                    
                    
                    131
                    
                    
                    
                    12
                    
                    
                    
                    9.2
                    %
                    
                    
                    422
                    
                    
                    
                    399
                    
                    
                    
                    23
                    
                    
                    
                    5.8
                    %FDIC
      insurance premiums
                    
                    
                    268
                    
                    
                    
                    235
                    
                    
                    
                    33
                    
                    
                    
                    14.0
                    %
                    
                    
                    779
                    
                    
                    
                    967
                    
                    
                    
                    (188
                    )
                    
                    
                    -19.4
                    %Other
                    
                    
                    402
                    
                    
                    
                    341
                    
                    
                    
                    61
                    
                    
                    
                    17.9
                    %
                    
                    
                    1,146
                    
                    
                    
                    1,039
                    
                    
                    
                    107
                    
                    
                    
                    10.3
                    %Total
                    
                    $
                    4,478
                    
                    
                    $
                    3,926
                    
                    
                    $
                    552
                    
                    
                    
                    14.1
                    %
                    
                    $
                    12,837
                    
                    
                    $
                    12,239
                    
                    
                    $
                    598
                    
                    
                    
                    4.9
                    %


- 48
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





NON-INTEREST
EXPENSE (Continued)





Quarter
to Quarter Comparison





Non-interest
expense is comprised of costs related to salaries and employee benefits, net
occupancy, furniture and equipment, marketing, third party services, FDIC
insurance premiums, regulatory assessments and taxes and various other operating
expenses. Total non-interest expense was $4,478,000 for the third quarter of
2010, an increase of $552,000 from the third quarter of 2009.





Salaries
and benefits is the largest component of non-interest expense. Salaries and
benefits expense increased $294,000, or 13.9%, to $2,409,000 for the quarter
ended September 30, 2010 compared to the same quarter in 2009. Salary expense
increased $237,000, or 13.8%, during the period to $1,958,000. This increase is
primarily attributable to $127,000 of severance related expenses for two former
officers of the Bank and an incentive compensation accrual of $101,000. There
was no incentive compensation accrual in the third quarter of 2009. In addition,
the average number of full time-equivalent employees increased by four, to 168,
when comparing the third quarter of 2010 and 2009. Comparing the two quarters,
benefits expense increased $57,000, or 14.5%, to $451,000. Increases in payroll
tax expense, retirement plan contribution expense and medical insurance premium
expense all contributed to the increase in benefit expense.





Net
occupancy expense increased $62,000, or 19.1%, to $386,000 for the third quarter
of 2010 compared to the same period in 2009. The majority of the increase
relates to the $35,000 increase in branch rent expense, primarily lease expense
for the land where the permanent Wescosville branch was built. This branch
opened in October 2010. Increases in utility costs related to rate increases and
usage also contributed $14,000 to the increase for the period.





Marketing
expense increased $30,000, to $155,000 for the quarter ended September 30, 2010.
The increase in marketing expense was the result of several community event
sponsorships during the quarter as well as an increase in advertising costs and
donations.





Third-party
services are comprised of professional services, including legal, accounting,
auditing and consulting services, as well as fees paid to outside vendors for
support services of day-to-day operations. These support services include
correspondent banking services, statement printing and mailing, investment
security safekeeping and supply management services. Third-party services
expense increased $45,000, or 20.6% to $263,000 for the three months ended
September 30, 2010 when compared to the same period in 2009. Increases in
accounting and auditing expense, consulting expense and information technology
service expense were the primary contributors to the increase in third-party
service expense.





FDIC
insurance premium expense increased $33,000, to $268,000, comparing the third
quarter of 2010 to 2009. Significant growth in deposits combined with a slightly
higher assessment rate were the underlying factors in the increase in the
premiums.





Other
expense increased $61,000 to $402,000 for the third quarter of 2010. The main
contributors to the increase in this category were as follows:


·
            Costs
      related to appraisals and title searches on loans, particularly classified
      loans, increased $26,000 when comparing the third quarter of 2010 to the
      same period in 2009. These expenses are a result of the Company’s ongoing
      efforts to obtain the most recent and relevant information to analyze
      classified loans in connection with the allowance for loan losses
      calculation.


·
            Expenses
      in connection with foreclosed real estate and repossessed assets increased
      $15,000, with the majority of the increase related to the payment of past
      due real estate taxes to preserve the Bank’s lien
  position.


·
            ATM
      fee refunds in connection with the QNB-Rewards checking account increased
      $6,000.





Nine
Month Comparison





Total
non-interest expense was $12,837,000 for the nine-month period ended September
30, 2010 compared to $12,239,000 for the same period in 2009, an increase of
$598,000, or 4.9%.


- 49
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





NON-INTEREST
EXPENSE (Continued)





Salaries
and benefits expense increased $442,000, or 7.0%, to $6,713,000 for the nine
months ended September 30, 2010 compared to the same period in 2009. Salary
expense increased $342,000, or 6.8%, during the period to $5,365,000. Similar to
the quarter, much of this increase is attributable to $127,000 of severance
related expenses and an incentive compensation accrual of $101,000. Excluding
these two items, salary expense increased 2.3% when comparing the nine-month
periods. Merit increases, as well as an increase in the average number of
full-time equivalent employees by four to 166 also contributed to the higher
salary expense. Included in salary and benefit expense for the first nine months
of 2009 were costs associated with the Chief Operating Officer position. This
position was vacant for eight out of the first nine months of 2010. Benefits
expense increased $100,000, or 8.0%, to $1,348,000 when comparing the nine-month
periods. Similar to the quarter, increases in payroll tax expense, retirement
plan contribution expense and medical insurance premium expense contributed to
the increase in benefit expense.





Net
occupancy expense increased $103,000, or 10.2%, to $1,115,000 for the first nine
months of 2010. Similar to the third quarter of 2010, higher branch rent related
to the land lease for the permanent site for the Wescosville branch and higher
utilities expenses contributed to the increase. In addition, for the first nine
months of 2010 building security expense increased $16,000, or 51.1%, when
compared to the same period in 2009. This increase is due to the ongoing
expenses of additional tracking devices added to the remainder of the
branches.





Third-party
service expense was $826,000 for the nine-month period ended September 30, 2010,
an increase of $111,000 from the same period in 2009. The largest portion of the
increase related to the following third-party services:


·
            Audit
      and accounting costs increased about $30,000 compared to prior year. The
      main contributors are costs associated with complying with the upcoming
      XBRL due date for the Company as well as additional services contracted
      with the Company’s outsourced internal audit firm related to
      Sarbanes-Oxley documentation and
testing.


·
            Consultant
      expense increased $24,000. The majority of the increase relates to the
      hiring of consultant to assist with leadership training and the use of an
      independent third party beginning in the second quarter of 2009 to analyze
      and value the Bank’s pooled trust preferred
  securities.


·
            Legal
      expense increased by $19,000 primarily as a result of loan collection
      costs.


·
            Costs
      associated with the registration, printing and mailing and ongoing
      expenses of the Dividend Reinvestment and Stock Purchase Plan contributed
      approximately $17,000 to the
increase.





FDIC
insurance premiums decreased $188,000, or 19.4%, to $779,000 for the nine months
ended September 30, 2010. The lower expense is a result of a special assessment
levied on all insured institutions by the FDIC during the second quarter of
2009. These actions were taken by the FDIC in order to replenish the Deposit
Insurance Fund which was reduced as a result of bank failures. The special
assessment contributed $332,000 to the total FDIC costs in 2009. There was no
similar special assessment in 2010. Partially offsetting this reduction in 2010
is significant growth in deposits combined with a slightly higher assessment
rate than prior year.





Other
expense increased $107,000 to $1,146,000 for the nine months ended September 30,
2010 compared to the same period in 2009. The following items were the primary
changes from prior year:


·
            Costs
      related to appraisals and title searches on loans, particularly classified
      loans, increased $43,000 when comparing the first nine months of 2010 to
      the same period in 2009. These expenses are a result of the Company’s
      ongoing efforts to obtain the most recent and relevant information to
      analyze classified loans in connection with the calculation of the
      allowance for loan losses.


·
            Directors’
      fees increased $31,000 for the first nine months of 2010 when compared to
      the same period in 2009. This was partly attributable to an increase in
      the number of meetings held and a portion of the increase is a result of
      deferred loan fees decreasing by $17,000. These fees have the impact of
      offsetting a portion of the Directors’ fees for loans that require
      Director approval. These fees were lower than prior year due a lower level
      of loans requiring Director approval during the first nine months of
      2010.


·
            Expenses
      in connection with foreclosed real estate and repossessed assets increased
      $19,000, with the majority of the increase related to the payment of past
      due real estate taxes to preserve the Bank’s lien
  position.


·
            Refund
      of ATM fees related to the QNB-Rewards product increased
      $17,000.


- 50
-


QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





NON-INTEREST
EXPENSE (Continued)





·
            Charge-offs
      related to fraudulent ATM and checkcard transactions increased
      $11,000.


·
            Employee
      training expenses decreased $25,000. Prior year included higher costs for
      service and sales training for branch and call center
      personnel.





INCOME
TAXES





QNB
utilizes an asset and liability approach for financial accounting and reporting
of income taxes. As of September 30, 2010, QNB’s net deferred tax asset was
$934,000. The primary components of deferred taxes are a deferred tax asset of
$2,765,000 relating to the allowance for loan losses, a deferred tax asset of
$269,000 generated by OTTI charges on equity securities and a deferred tax asset
of $435,000 related to OTTI charges on trust preferred securities. Partially
offsetting these deferred tax assets was a deferred tax liability of $2,270,000
resulting from unrealized gains on available-for-sale securities. As of
September 30, 2009, QNB’s net deferred tax asset was $584,000. The primary
components of deferred taxes are a deferred tax asset of $1,894,000 relating to
the allowance for loan losses, a deferred tax asset of $432,000 generated by
OTTI charges on equity securities, and a deferred tax asset of $259,000 related
to OTTI charges on trust preferred securities. Partially offsetting these
deferred tax assets was a deferred tax liability of $1,696,000 resulting from
unrealized gains on available for sale securities.





The
realizability of deferred tax assets is dependent upon a variety of factors,
including the generation of future taxable income, the existence of taxes paid
and recoverable, the reversal of deferred tax liabilities and tax planning
strategies. Based upon these and other factors, management believes it is more
likely than not that QNB will realize the benefits of these remaining deferred
tax assets. The net deferred tax asset is included in other assets on the
consolidated balance sheet.





Applicable
income taxes and effective tax rates were $349,000, or 17.7%, for the
three-month period ended September 30, 2010. As a result of the additional
provision for loan losses and the OTTI charges on the investment securities, QNB
recorded a tax benefit of $56,000 for the third quarter of 2009. For the
nine-month periods ended September 30, 2010 and 2009 applicable income taxes and
the effective tax rate were $1,419,000, or 20.8%, and $411,000, or 12.1%,
respectively. The higher effective tax rate for both periods in 2010 is
predominantly a result of tax-exempt income from loans and securities comprising
a lower proportion of pre-tax income.





FINANCIAL
CONDITION ANALYSIS





The
following balance sheet analysis compares average balance sheet data for the
nine months ended September 30, 2010 and 2009, as well as the period ended
balances as of September 30, 2010 and December 31, 2009.





Average
earning assets for the nine-month period ended September 30, 2010 increased
$67,423,000, or 10.0%, to $738,628,000 from $671,205,000 for the nine months
ended September 30, 2009. The mix of earning assets changed slightly when
comparing the two periods. Average loans increased $40,099,000, or 9.5%, while
average investment securities increased $17,789,000, or 7.4%. Average loans
represented 62.8% of earning assets for the first nine months of 2010, while
average investment securities represented 34.9% of earning assets for the same
period. This compares to 63.2% and 35.7%, respectively, for the first nine
months of 2009. Average other earning assets increased $10,861,000, or 180.6%,
when comparing these same periods. Given the low yield on Federal funds sold and
AAA rated money market mutual funds, QNB has chosen to keep excess liquidity in
an interest-bearing account at the Federal Reserve Bank that pays a higher rate
than these products and also has a zero percent risk-weighting for risk based
capital purposes.





QNB’s
primary business is accepting deposits and making loans to meet the credit needs
of the communities it serves. Loans are the most significant component of
earning assets and growth in loans to small businesses and residents of these
communities has been a primary focus of QNB. QNB has been successful in
achieving strong growth in total loans, while at the same time maintaining asset
quality. Inherent within the lending function is the evaluation and acceptance
of credit risk and interest rate risk. QNB manages credit risk associated with
its lending activities through portfolio diversification,


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MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





FINANCIAL
CONDITION ANALYSIS (Continued)





Average
total commercial loans increased $46,903,000 when comparing the first nine
months of 2010 to the first nine months of 2009. Most of the 14.9% growth in
average commercial loans was in loans secured by real estate, either commercial
or residential properties, which increased $33,443,000, or 15.5%, to
$249,497,000. Commercial and industrial loans represent commercial purpose loans
that are either secured by collateral other than real estate or unsecured. Many
of these loans are for operating lines of credit. Average commercial and
industrial loans increased $8,152,000, or 11.0%, when comparing the average
balances for the nine month periods. Tax-exempt loans to local municipalities
increased $5,308,000, or 21.3% to $30,242,000 during this same
period.





Average
home equity loans continue to decline with average balances decreasing from
$65,500,000 for the first nine months of 2009 to $60,610,000 for the first nine
months of 2010. With the decline in mortgage interest rates that took place,
customers have paid down their home equity loans when they refinance their first
mortgage. The other impact of the low interest rate environment is movement from
fixed rate home equity loans to floating rate lines tied to prime rate. Fixed
rate home equity term loans declined by $8,244,000 to $35,925,000 when comparing
the nine-month periods. In contrast average floating rate home equity lines have
increased by $3,354,000 comparing the same periods. The introduction of the
Equity Choice product, which allows both a floating rate line and fixed rate
carve out loans, contributed to this migration, as did the current low interest
rate on the variable rate product.





Total
investment securities were $282,098,000 at September 30, 2010 and $260,209,000
at December 31, 2009. The composition of the portfolio changed since December
31, 2009 with agency mortgage-backed and CMO securities increasing by
$10,641,000 and $9,722,000, respectively, when comparing December 31, 2009 and
September 30, 2010. In addition tax-exempt state and municipal bonds increased
$5,875,000 when comparing these same time periods. These increases were offset
by a decrease in U.S. Government agency bonds of $7,194,000 when comparing the
same periods. The agency bonds were callable bonds that were called due to the
low interest rate environment. The proceeds were reinvested in agency
mortgage-backed and CMO securities which will provide ongoing cash flow to
invest as rates increase. Yields on tax-exempt municipal bonds did not decline
to the degree that rates on other alternative investments did and therefore
provided value compared to these alternatives. As a result of the change in the
composition of the portfolio as well as the lower interest rate environment and
the increase in prepayment speeds the average life of the portfolio has declined
from approximately 3 years 5 months at December 31, 2009 to approximately 3
years 1 month at September 30, 2010.





Collateralized
debt obligations (CDO) are securities derived from the packaging of various
assets with many backed by subprime mortgages. These instruments are complex and
difficult to value. QNB did a review of its mortgage related securities and
concluded that it has minimal exposure to subprime mortgages within its U.S.
government sponsored agency (GNMA, FHLMC and FNMA) mortgage-backed and CMO
portfolio. QNB does not own any non-agency mortgage security or CDOs backed by
subprime mortgages.





QNB does
own CDOs in the form of pooled trust preferred securities. These securities are
comprised mainly of securities issued by banks, and to a lesser degree,
insurance companies. QNB owns the mezzanine tranches of these securities. These
securities are structured so that the senior and mezzanine tranches are
protected from defaults by over-collateralization and cash flow default
protection provided by subordinated tranches. QNB holds eight of these
securities with an amortized cost of $3,640,000 and a fair value of $1,665,000
at September 30, 2010. The market values for these securities are very depressed
relative to historical levels. A discounted cash flow analysis provides the best
estimate of credit related OTTI for these securities. During the first nine
months of 2010, a $277,000 credit related OTTI charge was taken on three issues.
As a result of some improvement in the financial condition of some of the bank
issuers in these securities, including the ability for some of them to raise
capital, the fair value of the securities has improved since December 31, 2009
when the fair value was $1,008,000. However, it is possible that future
calculations could require recording additional other-than-temporary impairment
charges through earnings.


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MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





FINANCIAL
CONDITION ANALYSIS (Continued)





For the
most part, earning assets are funded by deposits. Total average deposits
increased $72,894,000, or 12.5%, to $657,637,000 for the first nine months of
2010 compared to the first nine months of 2009. It appears that customers are
continuing to look for the safety of FDIC insured deposits and the stability of
a strong local community bank as opposed to the volatility of the equity markets
and the uncertainty of the larger regional and national banks. In addition, they
are looking for products that provide liquidity and an attractive interest
rate.





Most of
the increase in average deposits was in categories other than time deposits
which decreased $7,479,000, or 2.3%, to $318,939,000 for the first nine months
of 2010. Average interest-bearing demand and municipal accounts increased
$15,230,000, or 22.3%, and $5,950,000, or 19.0%, respectively, when comparing
the first nine months of 2010 and 2009. The higher yielding QNB-Rewards checking
product is the primary factor behind the growth of the interest-bearing demand
accounts. Average money market and savings account balances increased
$17,138,000, or 30.0%, and $39,290,000, or 81.0%, respectively, when comparing
the same periods. The growth in savings accounts is largely due to the success
of QNB’s newest high-rate deposit product, Online eSavings.





Total
assets at September 30, 2010 were $791,236,000 compared with $762,426,000 at
December 31, 2009, an increase of 3.8%. Impacting total assets was the repayment
of $10,000,000 in FHLB borrowings and $5,000,000 in repurchase agreements,
classified as long-term debt, which matured during the first six months of 2010.
Funding the growth in loans and investment securities previously discussed was
growth in deposits and short-term borrowings as well as the reduction in
interest-bearing deposits in banks. These balances, primarily held at the Fed,
declined from $22,158,000 at December 31, 2009 to $4,052,000 at September 30,
2010.





On the
liability side, total deposits increased by $40,144,000, or 6.3%, since
year-end. In comparison to prior periods where the growth was centered in time
deposits, the current growth reflects increases in both lower-cost core
deposits, including savings accounts. Savings accounts increased $35,436,000, or
51.8%, to $103,794,000. The increase in savings accounts was primarily in the
Online eSavings product whose balances increased from $19,944,000 at December
31, 2009 to $52,661,000 at September 30, 2010. Some of the growth in total
deposits is seasonal in nature, a result of being a depository for many school
districts in the area. Most of the school district taxes are collected during
the third quarter of the year and contributed to the $12,682,000, or 35.2%,
increase in municipal interest bearing demand account balances between December
31, 2009 and September 30, 2010. These funds will most likely be withdrawn over
the next nine months.





Short-term
borrowings increased $2,740,000 from $28,433,000 at December 31, 2009 to
$31,173,000 at September 30, 2010. The majority of these balances are commercial
sweep accounts which are volatile based on businesses receipt and disbursement
of funds. The category of other liabilities decreased from $6,899,000 at
December 31, 2009 to $1,649,000 at September 30, 2010. Included in the December
31, 2009 balance were unsettled trades of investment securities that settled in
January 2010.





LIQUIDITY





Liquidity
represents an institution’s ability to generate cash or otherwise obtain funds
at reasonable rates to satisfy demand for loans and deposit withdrawals. QNB
attempts to manage its mix of cash, Federal funds sold and investment securities
in order to match the volatility, seasonality, interest sensitivity and growth
trends of its loans and deposits. The Company manages its liquidity risk by
measuring and monitoring its liquidity sources and estimated funding needs.
Liquidity is provided from asset sources through maturities and repayments of
loans and investment securities. The portfolio of investment securities
classified as available-for-sale and QNB's policy of selling certain residential
mortgage originations in the secondary market also provide sources of liquidity.
Core deposits and cash management repurchase agreements have historically been
the most significant funding source for QNB. These deposits and repurchase
agreements are generated from a base of consumers, businesses and public funds
primarily located in the Company’s market area.


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MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





LIQUIDITY
(Continued)





Additional
sources of liquidity are provided by the Bank’s membership in the FHLB. At
September 30, 2010, the Bank had a maximum borrowing capacity with the FHLB of
approximately $207,515,000. The maximum borrowing capacity changes as a function
of qualifying collateral assets. In addition, the Bank maintains Federal funds
lines with two correspondent banks totaling $18,000,000. At September 30, 2010,
there were no outstanding borrowings under these lines. Future availability
under these lines is subject to the policies of the granting banks and may be
withdrawn.





Cash and
due from banks, interest-bearing deposits in banks, Federal funds sold,
investment securities available-for-sale and loans held-for-sale totaled
$292,285,000 and $288,395,000 at September 30, 2010 and December 31, 2009,
respectively. These sources should be adequate to meet normal fluctuations in
loan demand and deposit withdrawals. With the current low interest rate
environment, it is anticipated that the investment portfolio will continue to
provide significant liquidity as agency and municipal bonds are called and as
cash flow on mortgage-backed and CMO securities continues to be steady. In the
event that interest rates would increase the cash flow available from the
investment portfolio could decrease.





Approximately
$139,674,000 and $133,136,000 of available-for-sale securities at September 30,
2010 and December 31, 2009, respectively, were pledged as collateral for
repurchase agreements and deposits of public funds.





In 2008,
QNB opted into the FDIC’s Transaction Account Guarantee (TAG) program. This
program provides unlimited deposit insurance for non-interest bearing
transaction accounts. During the second quarter of 2010, the FDIC adopted a rule
extending the Transaction Account Guarantee (TAG) component of the Temporary
Liquidity Guarantee Program for six months, through December 31, 2010 for those
institutions that do not opt out. QNB continues to participate in the TAG
program.





As an
additional source of liquidity, QNB is a member of the Certificate of Deposit
Account Registry Service (CDARS) program offered by the Promontory
Interfinancial Network, LLC. CDARS is a funding and liquidity management tool
that is used by banks to access funds and manage their balance sheet. It enables
financial institutions to provide customers with full FDIC insurance on time
deposits over $250,000 that are placed in the program.





CAPITAL
ADEQUACY





A strong
capital position is fundamental to support continued growth and profitability
and to serve the needs of depositors. QNB's shareholders' equity at September
30, 2010 was $62,682,000, or 7.92% of total assets, compared to shareholders'
equity of $56,426,000, or 7.40% of total assets, at December 31, 2009.
Shareholders’ equity at September 30, 2010 and December 31, 2009 included a
positive adjustment of $4,407,000 and $1,723,000, respectively, related to net
unrealized holding gains, net of taxes, on investment securities
available-for-sale. Without these adjustments, shareholders' equity to total
assets would have been 7.37% and 7.17% at September 30, 2010 and December 31,
2009, respectively.





Average
shareholders' equity and average total assets were $56,966,000 and $767,990,000,
respectively, for the first nine months of 2010, an increase of 4.1% and 8.1%,
respectively, from the averages for the year ended December 31, 2009. The ratio
of average total equity to average total assets was 7.42% for the first nine
months of 2010 compared to 7.70% for all of 2009.





QNB is
subject to various regulatory capital requirements as issued by Federal
regulatory authorities. Regulatory capital is defined in terms of Tier I capital
(shareholders’ equity excluding unrealized gains or losses on available-for-sale
debt securities and disallowed intangible assets), Tier II capital, which
includes the allowance for loan losses and a portion of the unrealized gains on
equity securities, and total capital (Tier I plus Tier II). Risk-based capital
ratios are expressed as a percentage of risk-weighted assets. Risk-weighted
assets are determined by assigning various weights to all assets and off-balance
sheet arrangements, such as letters of credit and loan commitments, based on
associated risk. Regulators have also adopted minimum Tier I leverage ratio
standards, which measure the ratio of Tier I capital to total quarterly average
assets.


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MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS


CAPITAL
ADEQUACY (Continued)





The
following table sets forth consolidated information for QNB Corp.:





Capital AnalysisSeptember 30, 2010
                                                              
                                                              
                                                              December 31, 2009Tier
      IShareholder's
      Equity
                                                              
                                                              $
                                                              62,682
                                                              
                                                              
                                                              $
                                                              56,426Net
      unrealized securities gains
                                                              
                                                              
                                                              (4,407
                                                              )
                                                              
                                                              
                                                              (1,723
                                                              )Net
      unrealized losses on available-for-sale equity securities
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              -Total
      Tier I risk-based capital
                                                              
                                                              $
                                                              58,275
                                                              
                                                              
                                                              $
                                                              54,703Tier
      IIAllowable
      portion: Allowance for loan losses
                                                              
                                                              
                                                              7,043
                                                              
                                                              
                                                              
                                                              6,217Unrealized
      gains on equity securities
                                                              
                                                              
                                                              123
                                                              
                                                              
                                                              
                                                              248Total
      risk-based capital
                                                              
                                                              $
                                                              65,441
                                                              
                                                              
                                                              $
                                                              61,168Risk-weighted
      assets
                                                              
                                                              $
                                                              562,335
                                                              
                                                              
                                                              $
                                                              531,295Average
      assets
                                                              
                                                              $
                                                              784,500
                                                              
                                                              
                                                              $
                                                              745,551Capital
      RatiosSeptember 30, 2010
                                                              
                                                              
                                                              December 31, 2009Tier
      I capital/risk-weighted assets
                                                              
                                                              
                                                              10.36
                                                              %
                                                              
                                                              
                                                              10.30
                                                              %Total
      risk-based capital/risk-weighted assets
                                                              
                                                              
                                                              11.64
                                                              %
                                                              
                                                              
                                                              11.51
                                                              %Tier
      I capital/average assets (leverage ratio)
                                                              
                                                              
                                                              7.43
                                                              %
                                                              
                                                              
                                                              7.34
                                                              %





The
minimum regulatory capital ratios are 4.00% for Tier I, 8.00% for the total
risk-based capital and 4.00% for leverage. QNB had a Tier I capital ratio of
10.36% and 10.30%, a total risk-based ratio of 11.64% and 11.51% and a leverage
ratio of 7.43% and 7.34% at September 30, 2010 and December 31, 2009,
respectively.





All
regulatory capital ratios have improved slightly from December 31, 2009 as the
growth rate of Tier I and total risk based capital has exceeded the growth rate
of risk-weighted and quarterly average assets. During the first quarter of 2010,
QNB began offering a Dividend Reinvestment and Stock Purchase Plan (the “Plan”)
to provide participants a convenient and economical method for investing cash
dividends paid on the Company’s common stock in additional shares at a discount.
The Plan also allows participants to make additional cash purchases of stock at
a discount. Stock purchases under the Plan contributed $328,000 to capital for
the first nine months of 2010.





The Board
of Directors has authorized the repurchase of up to 100,000 shares of its common
stock in open market or privately negotiated transactions. The repurchase
authorization does not bear a termination date. As of September 30, 2010, 57,883
shares were repurchased under this authorization at an average price of $16.97
and a total cost of $982,000. There were no shares repurchased under the plan
since the first quarter of 2009.





Also
impacting the regulatory capital ratios was an increase in risk-weighted assets
during the first nine months of 2010. Loan growth, primarily centered in
commercial loans, accounted for virtually all of the $31,040,000 growth in
risk-weighted assets. Continuing to impact risk-weighted assets is the
$27,567,000 of risk-weighted assets due to mezzanine tranches of pooled trust
preferred securities that were downgraded below investment grade during the
first quarter of 2009. Although the amortized cost of these securities was only
$3,640,000 at September 30, 2010, regulatory guidance required an additional
$27,567,000 to be included in risk-weighted assets. The Bank utilized the method
as outlined in the Call Report Instructions for an available-for-sale bond that
has not triggered the Low Level Exposure (LLE) rule. The


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MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





CAPITAL
ADEQUACY (Continued)




The
Federal Deposit Insurance Corporation Improvement Act of 1991 established five
capital level designations ranging from "well capitalized" to "critically
undercapitalized." At September 30, 2010 and December 31, 2009, management
believes that the Company and the Bank met all capital adequacy requirements to
which they are subject and have met the "well capitalized" criteria which
requires minimum Tier I and total risk-based capital ratios of 6.00% and 10.00%,
respectively, and a leverage ratio of 5.00%.





INTEREST
RATE SENSITIVITY





Since the
assets and liabilities of QNB have diverse repricing characteristics that
influence net interest income, management analyzes interest sensitivity through
the use of gap analysis and simulation models. Interest rate sensitivity
management seeks to minimize the effect of interest rate changes on net interest
margins and interest rate spreads and to provide growth in net interest income
through periods of changing interest rates. QNB’s Asset/Liability Management
Committee (ALCO) is responsible for managing interest rate risk and for
evaluating the impact of changing interest rate conditions on net interest
income.





Gap
analysis measures the difference between volumes of rate-sensitive assets and
liabilities and quantifies these repricing differences for various time
intervals. Static gap analysis describes interest rate sensitivity at a point in
time. However, it alone does not accurately measure the magnitude of changes in
net interest income because changes in interest rates do not impact all
categories of assets and liabilities equally or simultaneously. Interest rate
sensitivity analysis also involves assumptions on certain categories of assets
and deposits. For purposes of interest rate sensitivity analysis, assets and
liabilities are stated at their contractual maturity, estimated likely call
date, or earliest repricing opportunity. Mortgage-backed securities, CMOs and
amortizing loans are scheduled based on their anticipated cash flow.
Interest-bearing demand accounts, money market accounts and savings accounts do
not have stated maturities or repricing terms and can be withdrawn or repriced
at any time. This may impact QNB’s margin if more expensive alternative sources
of deposits or borrowed funds are required to fund loans or deposit runoff.
Management projects the repricing characteristics of these accounts based on
historical performance and assumptions that it believes reflect their rate
sensitivity.





A
positive gap results when the amount of interest rate sensitive assets exceeds
interest rate sensitive liabilities. A negative gap results when the amount of
interest rate sensitive liabilities exceeds interest rate sensitive assets.
Generally a positive or asset sensitive position is beneficial in a rising rate
environment while a negative gap or liability sensitive position is beneficial
in a declining rate environment.





QNB
primarily focuses on the management of the one-year interest rate sensitivity
gap. The one-year cumulative gap, which reflects QNB’s interest sensitivity over
a period of time, was a negative $86,753,000 at September 30, 2010. The
cumulative one-year gap equals -11.3% of total rate sensitive assets. This
position compares to a negative gap position of $47,997,000, or -6.5% of total
rate sensitive assets, at December 31, 2009.





QNB also
uses a simulation model to assess the impact of changes in interest rates on net
interest income. The model reflects management’s assumptions related to asset
yields and rates paid on liabilities, deposit sensitivity, and the size,
composition and maturity or repricing characteristics of the balance sheet. The
assumptions are based on the interest rate environment at period end. Management
also evaluates the impact of higher and lower interest rates by simulating the
impact on net interest income of changing rates. While management performs rate
shocks of 100, 200 and 300 basis points, it believes that, given the level of
interest rates at September 30, 2010, it is unlikely that interest rates would
decline by 200 or 300 basis points. The simulation results can be found in the
chart below.


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MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





INTEREST
RATE SENSITIVITY (Continued)





Net
interest income declines in a falling rate environment. This result reflects
that income on earning assets would decline to a greater degree than the expense
associated with interest-bearing liabilities. In a lower rate environment, the
cash flow or repricing characteristics from both the loan and investment
portfolios would increase and be reinvested at lower rates resulting in less
income. Loan customers would likely either refinance their fixed rate loans at
lower rates or request rate reductions on their existing loans. While interest
expense on time deposits would decrease, the interest rate floors on some
municipal interest-bearing demand accounts, hypothetical interest rate floors on
interest-bearing transaction accounts, regular money market accounts and savings
accounts would prevent a reduction in interest expense on these
accounts.





Net
interest income increases compared to the base case flat rate scenario for the
first 200 basis point increase in rates as loans and investments reprice more
than rates on interest-bearing liabilities. The rate of increase in net interest
income declines the more rates increase because prepayments and calls on
investments and loans slow resulting in fewer amounts repricing at higher rates.
Actual results may differ from simulated results due to various factors
including time, magnitude and frequency of interest rate changes, the
relationship or spread between various rates, loan pricing and deposit
sensitivity, and asset/liability strategies.





The
results of the simulation model are inconsistent with the anticipated results
from using GAP analysis and highlight some of the weakness of just using GAP
analysis which for example does not take into consideration that rates on
different products do not change by the same magnitude and does not take into
consideration interest rates floors and caps.





Management
believes that the assumptions utilized in evaluating the vulnerability of QNB’s
net interest income to changes in interest rates approximate actual experience.
However, the interest rate sensitivity of QNB’s assets and liabilities as well
as the estimated effect of changes in interest rates on net interest income
could vary substantially if different assumptions are used or actual experience
differs from the experience on which the assumptions were based.





The
nature of QNB’s current operation is such that it is not subject to foreign
currency exchange or commodity price risk. At September 30, 2010, QNB did not
have any hedging transactions in place such as interest rate swaps, caps or
floors.





The table
below summarizes estimated changes in net interest income over a twelve-month
period, under alternative interest rate scenarios.





Change in Interest Rates
                        
                        Net InterestIncome
                        
                        
                        Dollar Change
                        
                        
                        % Change+300
      Basis Points
                        
                        $
                        28,449
                        
                        
                        
                        (180
                        )
                        
                        
                        -0.6
                        %+200
      Basis Points
                        
                        
                        28,825
                        
                        
                        
                        196
                        
                        
                        
                        0.7+100
      Basis Points
                        
                        
                        28,992
                        
                        
                        
                        363
                        
                        
                        
                        1.3Flat
      Rate
                        
                        
                        28,629
                        
                        
                        
                        -
                        
                        
                        
                        --100
      Basis Points
                        
                        
                        27,359
                        
                        
                        
                        (1,270
                        )
                        
                        
                        (4.4
                        )


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MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





ITEM 3.
            QUANTITATIVE
      AND QUALITATIVE DISCLOSURE ABOUT MARKET
RISK.





The
information required in response to this item is set forth in Item 2,
above.





ITEM 4.
            CONTROLS
      AND PROCEDURES





We
maintain a system of controls and procedures designed to provide reasonable
assurance as to the reliability of the consolidated financial statements and
other disclosures included in this report, as well as to safeguard assets from
unauthorized use or disposition. We evaluated the effectiveness of the design
and operation of our disclosure controls and procedures under the supervision
and with the participation of management, including our Chief Executive Officer
and Chief Financial Officer. Based upon that evaluation, our Chief Executive
Officer and Chief Financial Officer concluded that our disclosure controls and
procedures are effective as of the end of the period covered by this report. No
changes were made to our internal control over financial reporting during the
fiscal quarter covered by this report that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.


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QNB
CORP. AND SUBSIDIARY





PART
II.  OTHER INFORMATION





SEPTEMBER
30, 2010





Item 1.
            Legal
      Proceedings




None.





Item 1A.
            Risk
      Factors




There
were no material changes to the Risk Factors described in Item 1A in QNB’s
Annual Report on Form 10-K for the period ended December 31, 2009.





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




Period
                    
                    Total Number
                      of Shares
                      Purchased
                    
                    
                    Average Price
                      Paid per Share
                    
                    
                    Total Number
                      of Shares
                      Purchased as
                      Part of Publicly
                      Announced Plan
                    
                    
                    Maximum
                      Number of
                      Shares that may
                      yet be Purchased
                      Under the PlanJuly
      1, 2010 through July 31, 2010
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    42,117August
      1, 2010 through August 31, 2010
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    42,117September
      1, 2010 through September 30, 2010
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    42,117Total
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    42,117




(1)
            Transactions
      are reported as of settlement
dates.


(2)
            QNB’s
      current stock repurchase plan was approved by its Board of Directors and
      announced on January 24, 2008 and subsequently increased on February 9,
      2009.


(3)
            The
      total number of shares approved for repurchase under QNB’s current stock
      repurchase plan is 100,000.


(4)
            QNB’s
      current stock repurchase plan has no expiration
  date.


(5)
            QNB
      has no stock repurchase plan that it has determined to terminate or under
      which it does not intend to make further
  purchases.





Item 3.
            Default Upon Senior
      Securities


None.


Item 4.
            (Removed and
      Reserved)





Item 5.
            Other
      Information




None.


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-


Item 6.
            Exhibits




Exhibit
      3(i)
                
                Articles
      of Incorporation of Registrant, as amended. (Incorporated by reference to
      Exhibit 3(i) of Registrants Form DEF 14-A filed with the Commission on
      April 15, 2005).Exhibit
      3(ii)
                
                Bylaws
      of Registrant, as amended. (Incorporated by reference to Exhibit 3(ii) of
      Registrants Form 8-K filed with the Commission on January 23,
      2006).Exhibit
      11
                
                Statement
      Re: Computation of Earnings Per Share. (Included in Part I, Item I,
      hereof.)Exhibit
      31.1
                
                Section
      302 Certification of Chief Executive OfficerExhibit
      31.2
                
                Section
      302 Certification of Chief Financial OfficerExhibit
      32.1
                
                Section
      906 Certification of Chief Executive OfficerExhibit
      32.2
                
                Section
      906 Certification of Chief Financial
Officer


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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.





QNB
      Corp.Date:   November
      15, 2010
                      By:
                      /s/ Thomas J. BiskoThomas
      J. BiskoChief
      Executive OfficerDate:   November
      15, 2010
                      By:
                      /s/ Bret H. KrevolinBret
      H. KrevolinChief
      Financial
Officer


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