UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-K





FOR
ANNUAL AND TRANSITION REPORTS


PURSUANT
TO SECTIONS 13 OR 15(d) OF


THE
SECURITIES EXCHANGE ACT OF 1934





[X]
Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange


Act of
1934


For the
Fiscal Year Ended December 31, 2008


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 No. 0-25766





Community Bank Shares of
Indiana, Inc.





(Exact
Name of Registrant as Specified in its Charter)





Indiana
            35-1938254(State
      or Other Jurisdiction of
            (I.R.S.
      EmployerIncorporation
      or Organization)
            Identification
      Number)





101 West Spring Street, New
Albany, Indiana 47150


(Address
of Principal Executive Offices) (Zip Code)





Registrant's
telephone number, including area code: (812)
944-2224





Securities Registered
Pursuant to Section 12(b) of the Act:


Title of Each Class
            Name of Each Exchange on Which
      RegisteredCommon
      Stock, par value $0.10 per share
            NASDAQ
      National Market





Securities Registered
Pursuant to Section 12(g) of the Act:


None





Indicate
by checkmark if the Registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  YES_NOX_





Indicate
by checkmark if the Registrant is not required to file requests pursuant to
Section 13 or 15(d) of the Act.  YES_NOX_





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 twelve months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
requirements for the past 90 days.  YESXNO__





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.     x














1




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 X_Smaller reporting
company __




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




As of
June 30, 2008, the aggregate market value of the Registrant’s common stock held
by non-affiliates of the Registrant was $44,717,422 based on the closing sale
price as reported on the National Association of Securities Dealers Automated
Quotation System National Market System.  Shares of common stock held
by each officer, director, and holder of 10% or more of the outstanding common
stock of the Registrant have been excluded from this calculation in that such
persons may be deemed to be affiliates.  This determination of
affiliate status is not necessarily a conclusive determination for other
purposes.




As of
March 19, 2009, there were issued and outstanding 3,251,437 shares of the
Registrant's Common Stock.





DOCUMENTS
INCORPORATED BY REFERENCE





Portions
of the Registrant’s definitive Proxy Statement for its Annual Meeting of
Stockholders to be held on May 19, 2009 are incorporated by reference into Items
10, 11, 12, 13 and 14 of Part III.




2






Form
      10-KIndexPart I:
                  
                  PageItem
      1.
                  Business
                  4Item
      1A
                  Risk
      Factors
                  12Item 1B
                  Unresolved Staff
      Comments
                  17Item
      2.
                  Properties
                  18Item
      3.
                  Legal
      Proceedings
                  19Item
      4.
                  Submission of
      Matters to a Vote of Security Holders
                  19Part II:Item
      5.
                  M arMarket for
      Registrant's Common Equity, Related Stockholder Matters and
      Issuer Purchases of Equity Securities
                  20Item
      6.
                  Selected
      Financial Data
                  22Item
      7.
                  ManManagement's
      Discussion and Analysis of Financial Condition and Results of
      Operations
                  23Item
      7A.
                  Quantitative
      and Qualitative Disclosures about Market Risk
                  45Item
      8.
                  Financial
      Statements and Supplementary Data
                  48Item
      9.
                  Changes in and
      Disagreements with Accountants on Accounting and Financial
      Disclosures
                  93Item
      9A.
                  Controls and
      Procedures
                  93Item
      9B
                  Other
      Information
                  95Part III:Item
      10.
                  Directors and
      Executive Officers of the Registrant
                  95Item
      11.
                  Executive
      Compensation
                  95Item
      12.
                  Sec  Security Ownership of Certain Beneficial
      Owners and Management and Related Stockholder
      Matters
                  95Item
      13.
                  Certain
      Relationships and Related Transactions
                  95Item
      14.
                  Principal
      Accountant Fees and Services
                  95Part IV:Item
      15.
                  Exhibits and
      Financial Statement Schedules
                  96Signatures
                  
                  97Index of
      Exhibits
                  
                  98


3


Part
I





Item
1.  Business





General





Community
Bank Shares of Indiana, Inc. (the “Company”) is a bank holding company
headquartered in New Albany, Indiana. The Company’s wholly-owned banking
subsidiaries are Your Community Bank (“YCB”), which changed its name effective
November 1, 2005, from Community Bank of Southern Indiana, and The Scott County
State Bank (“SCSB”), which was acquired on July 1, 2006 through the Company’s
acquisition of The Bancshares, Inc (YCB and SCSB are at times collectively
referred to herein as the “Banks”).  Until November 14, 2003, the
Company also operated four bank offices in Jefferson and Nelson County, Kentucky
through its wholly-owned banking subsidiary, Community Bank of Kentucky, Inc.
(“CBKY”).  On November 14, 2003 CBKY was merged with and into
YCB.  The Banks are state-chartered commercial banks headquartered in
New Albany, Indiana and Scottsburg, Indiana, respectively, and are both
regulated by the Indiana Department of Financial Institutions.  YCB is
also regulated by the Federal Deposit Insurance Corporation and (with respect to
its Kentucky branches) the Kentucky Office of Financial Institutions while SCSB
is also regulated by the Federal Reserve.





YCB has
three wholly-owned subsidiaries to manage its investment portfolio. CBSI
Holdings, Inc. and CBSI Investments, Inc. are Nevada corporations which jointly
own CBSI Investment Portfolio Management, LLC, a Nevada limited liability
corporation which holds and manages investment securities previously owned by
the Bank.





YCB also
has a Community Development Entity (CDE) subsidiary named CBSI Development Fund,
Inc.  The CDE enables YCB to participate in the federal New Markets
Tax Credit (NMTC) Program.  The NMTC Program is administered by the
Community Development Financial Institutions Fund of the United States Treasury
and is designed to promote investment in low-income communities by providing a
tax credit over seven years for equity investments in CDE’s.





In June
2004 and June 2006, the Company completed placements of floating rate
subordinated debentures through two trusts formed by the Company, Community Bank
Shares (IN) Statutory Trust I and Trust II (“Trusts”).  Because the
Trusts are not consolidated with the Company, pursuant to FASB Interpretation
No. 46R, the Company’s financial statements reflect the subordinated debt issued
by the Company to the Trusts.





The
Company had total assets of $877.4 million, total deposits of $603.2 million,
and stockholders' equity of $62.6 million as of December 31, 2008. The Company's
principal executive office is located at 101 West Spring Street, New Albany,
Indiana 47150, and the telephone number at that address is (812)
944-2224.





Business
Strategy





The
Company's current business strategy is to operate well-capitalized, profitable
and independent community banks with a significant presence in their primary
market areas.  The Company’s growth strategy is focused on expansion
through organic growth within its market areas.  The Company offers
business and personal banking services through a full range of deposit products
that include non-interest and interest-bearing checking accounts, ATM’s, debit
cards, savings accounts, money market accounts, certificates of deposit and
individual retirement accounts.  The Company’s loan products
include:  secured and unsecured business loans of various terms to
local businesses and professional organizations; consumer loans including home
equity lines of credit, automobile and recreational vehicle, credit cards,
construction, and loans secured by deposit accounts; and residential real estate
loans.   In addition, the Company also offers non-deposit
investment products such as stocks, bonds, mutual funds, and annuities to
customers within its banking market areas through a strategic alliance with
Smith Barney.





Internal Growth.Management
believes the optimum way to grow the Company is by attracting new loan and
deposit customers within its existing markets through its extensive product
offerings and attentive customer service.  Management believes the
Company’s customers seek a banking relationship with a service-oriented
community banking institution and feels the Company’s banking centers have an
atmosphere which facilitates personalized service and a broad range of product
offerings to meet customers’ needs.However, the Company
will consider acquisition opportunities that help advance its strategic
objectives.





Branch Expansion.Management
continues to consider opportunities for branch expansion and is focusing its
current efforts within existing markets. Management considers a variety of
criteria when evaluating potential branching opportunities.  These
include:  the market location of the potential branch and demographics
of the surrounding communities; the investment required and opportunity costs;
staffing needs; and other criteria management deems of particular
importance.







4
 Index


Lending
Activities





Commercial Business Loans.
The Company originates non-real estate related business loans to local
businesses and professional organizations.  This type of commercial
loan has been offered at both variable rates and fixed rates and can be
unsecured or secured by general business assets such as equipment, accounts
receivable or inventory.  Such loans generally have shorter terms and
higher interest rates than commercial real estate loans. However, commercial
business loans also involve a higher level of credit risk because of the type
and nature of the collateral.





Commercial Real Estate
Loans.  The Company's commercial real estate loans are secured
by improved property such as offices, small business facilities, apartment
buildings, nursing homes, warehouses and other non-residential buildings, most
of which are located in the Company's primary market area and some of which are
to be used or occupied by the borrowers. Commercial real estate loans have been
offered at adjustable interest rates and at fixed rates with balloon provisions
at the end of the term financing. The Company continues to originate commercial
real estate loans, commercial real estate construction and development loans and
land loans.  Loans secured by commercial real estate generally involve
a greater degree of risk than residential mortgage loans and carry larger loan
balances. This increased credit risk is a result of several factors, including
the concentrations of principal in a limited number of loans and borrowers, the
effects of general economic conditions on income producing properties, and the
increased difficulty of evaluating and monitoring these types of loans.
Furthermore, the repayment of loans secured by multifamily and commercial real
estate is typically dependent upon the successful operation of the related real
estate project. If the cash flow from the project is reduced, the borrower's
ability to repay the loan may be impaired. The Company has sought to increase
its origination of multi-family residential or commercial real estate loans over
the last few years and has attempted to protect itself against the increased
credit risk associated with these loans through its underwriting standards and
ongoing monitoring processes.





Residential Real Estate
Loans. The Company originates one-to-four family, owner-occupied,
residential mortgage loans secured by property located in the Company's market
area.  While the Company currently sells a portion of its residential
real estate loans into the secondary market, the Company does originate and
retain a significant amount of these loans in its own portfolio.  The
majority of the Company's residential mortgage loans consist of loans secured by
owner-occupied, single family residences.  The Company currently
offers residential mortgage loans for terms up to thirty years, with adjustable
(“ARM”) or fixed interest rates. Origination of fixed-rate mortgage loans versus
ARM loans is monitored continuously and is affected significantly by the level
of market interest rates, customer preference, and loan products offered by the
Company's competitors. Therefore, even if management's strategy is to emphasize
ARM loans, market conditions may be such that there is greater demand for
fixed-rate mortgage loans and/or fixed rate mortgage loans with balloon payment
features.





The
Company's fixed and adjustable rate residential mortgage loans are amortized on
a monthly basis with principal and interest due each month. Residential real
estate loans often remain outstanding for significantly shorter periods than
their contractual terms because borrowers may refinance or prepay loans at their
option.





The
primary purpose of offering ARM loans is to make the Company's loan portfolio
more interest rate sensitive. ARM loans, however, can carry increased credit
risk because during a period of rising interest rates the risk of default on ARM
loans may increase due to increases in borrowers’ monthly payments.





After the
initial fixed rate period, the Company's ARM loans generally adjust annually
with interest rate adjustment limitations of two percentage points per year and
six percentage points over the life of the loan. The Company also makes ARM
loans with interest rates that adjust every one, three or five years. Under the
Company's current practice, after the initial fixed rate period the interest
rate on ARM loans adjusts to the applicable index plus a spread. The Company's
policy is to qualify borrowers for one-year ARM loans based on the initial
interest rate plus the maximum annual rate increase.











5
 Index





The
Company has used different indices for its ARM loans such as the National
Average Median Cost of Funds, the Sixth District Net Cost of Funds Monthly
Index, the National Average Contract Rate for Previously Occupied Homes, the
average three year Treasury Bill Rate, and the Eleventh District Cost of Funds.
Consequently, the adjustments in the Company's portfolio of ARM loans tend not
to reflect any one particular change in any specific interest rate index, but
general interest rate trends overall.





Secondary
market regulations limit the amount that a bank may lend based on the appraised
value of real estate.  Such regulations permit a maximum loan-to-value
ratio of 95% percent for residential property and from 65-90% for all other real
estate related loans.





The
Company occasionally makes real estate loans with loan-to-value ratios in excess
of 80%.  For the loans sold into the secondary market, individual
investor requirements pertaining to private mortgage insurance
apply.  For the mortgage real estate loans retained by the Company
with loan-to-value ratios of 80-90%, the Company may require the first 20% of
the loan to be covered by private mortgage insurance. For the mortgage real
estate loans retained by the Company with loan-to-value ratios of 90-95%, the
Company may require private mortgage insurance to cover the first 25-30% of the
loan amount. The Company requires fire and casualty insurance, as well as title
insurance or an opinion of counsel regarding good title, on all properties
securing real estate loans made by the Company.





Construction Loans. The
Company originates loans to finance the construction of owner-occupied
residential property. The Company makes construction loans to private
individuals for the purpose of constructing a personal residence or to local
real estate builders and developers. Construction loans generally are made with
either adjustable or fixed-rate terms, typically up to 12 months. Loan proceeds
are disbursed in increments as construction progresses and as inspections
warrant. Construction loans are structured to be converted to permanent loans at
the end of the construction period or to be terminated upon receipt of permanent
financing from another financial institution.





Consumer Loans. The principal
types of consumer loans offered by the Company are home equity lines of credit,
auto loans, home improvement loans, and loans secured by deposit
accounts.  Home equity lines of credit are predominately made at rates
which adjust periodically and are indexed to the prime rate. Some consumer loans
are offered on a fixed-rate basis depending upon the borrower's preference. The
Company's home equity lines of credit are generally secured by the borrower's
principal residence and a personal guarantee.





The
underwriting standards employed by the Company for consumer loans include a
determination of the applicant's credit history and an assessment of the
prospective borrower’s ability to meet existing obligations and payments on the
proposed loan. The stability of the applicant's monthly income may be determined
by verification of gross monthly income from primary employment and from any
verifiable secondary income.  The underwriting process also includes a
comparison of the value of the collateral in relation to the proposed loan
amount.





Mortgage-Banking
Operations.  The Company originates qualified government
guaranteed loans and conventional secondary market loans which are generally
sold with the servicing released. This arrangement provides necessary liquidity
to the Company while providing additional loan products to the Company’s
customers.





Loan Solicitation and
Processing. Loans are originated through a number of sources including
loan sales staff, real estate broker referrals, existing customers, borrowers,
builders, attorneys and walk-in customers. Processing procedures are affected by
the type of loan requested and whether the loan will be funded by the Company or
sold into the secondary market.





Mortgage
loans that are sold into the secondary market are submitted, when possible, for
Automated Underwriting, which allows for faster approval and an expedited
closing. The Company’s responsibility on these loans is the fulfillment of the
loan purchaser's requirements. These loans often have reduced underwriting
features and may be made without an appraisal or credit report at the option of
the purchaser.  Loans that are reviewed in a more traditional manner,
which are mostly loans held for the Company's own portfolio, require credit
reports, appraisals, and income verification before they are approved or
disapproved.  Private mortgage insurance is generally required on
loans with a ratio of loan to appraised value of greater than eighty percent.
Property insurance and flood certifications are required on all real estate
loans.








6
 Index


Installment
loan documentation varies by the type of collateral offered to secure the loan.
In general, an application and credit report is required before a loan is
submitted for underwriting. The underwriter determines the necessity of any
additional documentation, such as income verification or appraisal of
collateral. An authorized loan officer approves or declines the loan after
review of all applicable loan documentation collected during the underwriting
process.





Commercial
loans are underwritten by the commercial loan officer who makes the initial
contact with the customer applying for credit. The underwriting of these loans
is reviewed after the fact by the Risk Management area for compliance with the
Company's general underwriting standards. A loan exceeding the authority of the
underwriting loan officer requires the approval of other officers of the Banks
based upon individual lending authorities, the Executive Committee, or the Board
of Directors of the Banks, depending on the loan amount.





Loan Commitments. The Company
issues loan origination commitments to qualified borrowers primarily for the
construction and purchase of residential real estate and commercial real estate.
Such commitments are made with specified terms and conditions for periods of
thirty days for commercial real estate loans and sixty days for residential real
estate loans.





Employees





As of
December 31, 2008, the Company employed 253 employees, 230 full-time and 23
part-time.  None of these employees are represented by a collective
bargaining group. Neither the Company nor any subsidiary has ever experienced a
work stoppage.





Competition
and Market Area Served





The
banking business is highly competitive, and as such the Company competes not
only with other commercial banks, but also with savings and loan associations,
trust companies and credit unions for deposits and loans, as well as stock
brokerage firms, insurance companies, and other entities providing one or more
of the services and products offered by the Company. In addition to competition,
the Company's business and operating results are affected by the general
economic conditions prevalent in its market.





The
Company’s primary market areas consist of Floyd, Clark, and Scott counties in
Southern Indiana and Jefferson and Nelson counties in Kentucky.  These
are four (excluding Scott County) of the thirteen counties comprising the
Louisville, Kentucky Standard Metropolitan Statistical Area, which has a
population in excess of 1.2 million.  The aggregate population of
Floyd, Clark, and Scott counties is approximately 202,000 while the populations
of Jefferson and Nelson Counties are approximately 709,000 and 43,000,
respectively. The Company's headquarters are located in New Albany, Indiana, a
city of 37,000 located approximately three miles from the center of
Louisville.





Nature
of Company’s Business





The
business of the Company is not seasonal.  The Company’s business does
not depend upon a single customer, or a few customers, the loss of any one or
more of which would have a material adverse effect on the Company.  No
material portion of the Company’s business is subject to renegotiation of
profits or termination of contracts or subcontracts at the election of any
governmental entity.





Regulation
and Supervision





As a bank
holding company, the Company is regulated under the Bank Holding Company Act of
1956, as amended (the "Act"). The Act limits the business of bank holding
companies to banking, managing or controlling banks and other subsidiaries
authorized under the Act, performing certain servicing activities for
subsidiaries and engaging in such other activities as the Board of Governors of
the Federal Reserve System (“Federal Reserve Board”) may determine to be closely
related to banking. The Company is registered with and is subject to regulation
by the Federal Reserve Board. Among other things, applicable statutes and
regulations require the Company to file an annual report and such additional
information as the Federal Reserve Board may require pursuant to the Act and the
regulations which implement the Act. The Federal Reserve Board also conducts
examinations of the Company.











7
 Index
  The Act
provides that a bank holding company must obtain the prior approval of the
Federal Reserve Board to acquire more than five percent of the voting stock or
substantially all the assets of any bank or bank holding company. The Act also
provides that, with certain exceptions, a bank holding company may not (i)
engage in any activities other than those of banking or managing or controlling
banks and other authorized subsidiaries, or (ii) own or control more than five
percent of the voting shares of any company that is not a bank, including any
foreign company. A bank holding company is permitted, however, to acquire shares
of any company, the activities of which the Federal Reserve Board has determined
to be so closely related to banking or managing or controlling banks as to be a
proper incident thereto.  A bank holding company may also acquire
shares of a company which furnishes or performs services for a bank holding
company and acquire shares of the kinds and in the amounts eligible for
investment by national banking associations. In addition, the Federal Reserve
Act restricts the Bank’s extension of credit to the Company.





On
November 12, 1999, Congress enacted the Gramm-Leach-Bliley Act. The
Gramm-Leach-Bliley Act permits bank holding companies to qualify as "financial
holding companies" that may engage in a broad range of financial activities,
including underwriting, dealing in and making a market in securities, insurance
underwriting and agency activities and merchant banking. The Federal Reserve
Board is authorized to expand the list of permissible financial activities. The
Gramm-Leach-Bliley Act also authorizes banks to engage through financial
subsidiaries in nearly all of the activities permitted for financial holding
companies. The Company has not elected the status of financial holding company
and at this time has no plans for these investments or broader financial
activities.





As
state-chartered commercial banks, the Company’s subsidiary banks are subject to
examination, supervision and extensive regulation by the Federal Deposit
Insurance Corporation (“FDIC”), the Indiana Department of Financial Institutions
(“DFI”) and (with respect to YCB and its branch offices located in Kentucky) the
Kentucky Office of Financial Institutions (“KOFI). The Banks are members of and
own stock in the Federal Home Loan Bank (“FHLB”) of Indianapolis and Cincinnati.
The FHLB institutions located in Indianapolis and Cincinnati are two of the
twelve regional banks in the FHLB system. The Banks are also subject to
regulation by the Federal Reserve Board, which governs reserves to be maintained
against deposits and regulates certain other matters. The extensive system of
banking laws and regulations to which the Banks are subject is intended
primarily for the protection of the Company’s customers and depositors, and not
its shareholders.





The FDIC,
Federal Reserve, and DFI/KOFI regularly examine the Banks and prepare reports
for the consideration of the Banks’ Board of Directors on any deficiencies that
they may find in the Banks’ operations. The relationship of the Banks with their
depositors and borrowers also is regulated to a great extent by both federal and
state laws, especially in such matters as the form and content of the Banks’
mortgage documents and communication of loan and deposit rates to both existing
and prospective customers.





The
investment and lending authority of a state-chartered bank is prescribed by
state and federal laws and regulations, and such banks are prohibited from
engaging in any activities not permitted by such laws and regulations. These
laws and regulations generally are applicable to all state chartered banks. The
Banks may not lend to a single or related group of borrowers on an unsecured
basis an amount in excess of the greater of $500,000 or fifteen percent of the
Banks unimpaired capital and surplus on a disaggregated basis. An additional
amount may be lent, equal to ten percent of unimpaired capital and surplus, if
such loan is secured by readily marketable collateral, which is defined to
include certain securities, but generally does not include real
estate.





Federal
Regulations





Sections
22(h) and (g) of the Federal Reserve Act place restrictions on loans to
executive officers, directors and principal stockholders. Under Section 22(h),
loans to a director, an executive officer and to a greater than ten percent
stockholder of a bank, and certain affiliated interests of either, may not
exceed, together with all other outstanding loans to such person and affiliated
interests, the institution's loans to one borrower limit (15% of the Bank’s
unimpaired capital and surplus). Section 22(h) also requires that loans to
directors, executive officers and principal stockholders be made on terms
substantially the same as offered in comparable transactions to other persons
and also requires prior board of directors approval for certain loans. In
addition, the aggregate amount of extensions of credit to all insiders cannot
exceed the institution's unimpaired capital and surplus. At December 31, 2008
the Banks were in compliance with the above restrictions.











8
 Index








Safety and Soundness. The
Federal Deposit Insurance Act (“FDIA”), as amended by the Federal Deposit
Insurance Corporation Improvement Act of 1991 (“FDICIA”) and the Riegle
Community Development and Regulatory Improvement Act of 1994, requires the
federal bank regulatory agencies to prescribe standards, by regulations or
guidelines, relating to the internal controls, information systems and internal
audit systems, loan documentation, credit underwriting, interest-rate-risk
exposure, asset growth, asset quality, earnings, stock valuation and
compensation, fees and benefits and such other operational and managerial
standards as the agencies may deem appropriate. The federal bank regulatory
agencies adopted, effective August 9, 1995, a set of guidelines prescribing
safety and soundness standards pursuant to FDICIA, as amended. In general, the
guidelines require, among other things, appropriate systems and practices to
identify and manage the risks and exposures specified in the
guidelines.





The FDIC
generally is authorized to take enforcement action against a financial
institution that fails to meet its capital requirements; such action may include
restrictions on operations and banking activities, the imposition of a capital
directive, a cease and desist order, civil money penalties or harsher measures
such as the appointment of a receiver or conservator or a forced merger into
another institution. In addition, under current regulatory policy, an
institution that fails to meet its capital requirements is prohibited from
paying any dividends. Except under certain circumstances, further disclosure of
final enforcement action by the FDIC is required.





Prompt Corrective Action.
Under Section 38 of the FDIA, as amended by the FDICIA, each federal banking
agency was required to implement a system of prompt corrective action for
institutions which it regulates. The federal banking agencies, including the
FDIC, adopted substantially similar regulations to implement Section 38 of the
FDIA, effective as of December 19, 1992. Under the regulations, an institution
is deemed to be (i) "well-capitalized" if it has total risk-based capital of
10.0% or more, a Tier 1 risk-based capital ratio of 6.0% or more, a Tier 1
leverage capital ratio of 5.0% or more and is not subject to any order or final
capital directive to meet and maintain a specific capital level for any capital
measure, (ii) "adequately-capitalized" if it has a total risk-based capital
ratio of 8.0% or more, a Tier 1 risk-based capital ratio of 4.0% or more and a
Tier 1 leverage capital ratio of 4.0% or more (3.0% under certain circumstances)
and does not meet the definition of "well-capitalized," (iii) "undercapitalized"
if it has a total risk-based capital ratio that is less than 8.0%, a Tier 1
risk-based capital ratio that is less than 4.0% or a Tier 1 leverage capital
ratio that is less than 4.0% ( 3.0% under certain circumstances), (iv)
"significantly undercapitalized" if it has a total risk-based capital ratio that
is less than 6.0%, a Tier 1 risk-based capital ratio that is less than 3.0% or a
Tier II average capital ratio that is less than 3.0%, and (v) "critically
undercapitalized" if it has a ratio of tangible equity to total assets that is
equal to or less than 2.0%. Section 38 of the FDIA and the regulations
promulgated thereunder also specify circumstances under which a federal banking
agency may reclassify a well-capitalized institution as adequately-capitalized
and may require an adequately-capitalized institution or an undercapitalized
institution to comply with supervisory actions as if it were in the next lower
category (except that the FDIC may not reclassify a significantly
undercapitalized institution as critically undercapitalized). At December 31,
2008, the Company and the Banks were deemed well-capitalized for purposes of the
above regulations.





Federal Home Loan Bank
System. The Banks are members of the FHLB of Indianapolis and
Cincinnati.  The FHLB of Indianapolis and Cincinnati are two of the 12
regional FHLB's that, prior to the enactment of FIRREA, were regulated by the
Federal Home Loan Bank Board (FHLBB). FIRREA separated the home financing credit
function of the FHLB's from the regulatory functions of the FHLB's regarding
savings institutions and their insured deposits by transferring oversight over
the FHLB's from the FHLBB to a new federal agency, the Federal Home Financing
Board ("FHFB").  On July 30, 2008, the Federal Housing Finance Agency
(“FHFA”) was created due to the enactment of the Housing and Economic Recovery
Act of 2008.  The Act empowered the FHFA with the powers to oversee
and regulate Fannie Mae, Freddie Mac, and the FHLBs.





As
members of the FHLB system, the Banks are required to purchase and maintain
stock in the FHLB in an amount equal to the greater of one percent of its
aggregate unpaid residential mortgage loans, home purchase contracts or similar
obligations at the beginning of each year, or 1/20 (or such greater fraction as
established by the FHLB) of outstanding FHLB advances. At December 31, 2008,
$7.6 million of FHLB stock was outstanding for the Banks, which were in
compliance with this requirement. In past years, the Banks have received
dividends on its FHLB stock.














9
 Index





Insurance of Accounts. Prior
to October 2, 2008, the Banks’ deposits were insured up to $100,000 per insured
member (as defined by law and regulation).  Effective October 3, 2008,
the basic limit on federal deposit insurance coverage was temporarily increased
from $100,000 to $250,000 per depositor through December 31, 2009. On January 1,
2010, FDIC deposit insurance for all deposit accounts—except for certain
retirement accounts—will return to at least $100,000 per depositor. Insurance
coverage for certain retirement accounts, which include all IRA deposit
accounts, was increased permanently to $250,000 per depositor in 2006. This
insurance is backed by the full faith and credit of the United States
Government.  Certain deposits assumed by YCB upon the merger of
Heritage Bank of Southern Indiana into YCB in 2002 (which are insured by the
Bank Insurance Fund (BIF)), are insured by the Savings Association Insurance
Fund (SAIF).  The SAIF and the BIF are both administered and managed
by the FDIC. As insurer, the FDIC is authorized to conduct examinations of and
to require reporting by SAIF and BIF insured institutions. It also may prohibit
any insured institution from engaging in any activity the FDIC determines by
regulation or order to pose a serious threat to either fund. The FDIC also has
the authority to initiate enforcement actions against financial institutions.
The annual assessment for deposit insurance is based on a risk-related premium
system. Each insured institution is assigned to one of three capital groups:
well-capitalized, adequately-capitalized or undercapitalized. Within each
capital group, institutions are assigned to one of three subgroups (A, B, or C)
on the basis of supervisory evaluations by the institution's primary federal
supervisor and if applicable, state supervisor. Assignment to one of the three
capital groups, coupled with assignment to one of three supervisory subgroups,
will determine which of the four risk classifications is appropriate for an
institution. Institutions are assessed insurance rates based on their assigned
risk classifications. The well-capitalized, subgroup "A" category institutions
are assessed the lowest insurance rate, while institutions assigned to the
undercapitalized subgroup "C" category are assessed the highest insurance
rate.  As of December 31, 2008, SCSB was assigned to the
well-capitalized, subgroup "A" category and paid an annual insurance rate of 5.5
cents per $100 of deposits while YCB was assigned to the well-capitalized,
subgroup “B” category and paid an annual insurance rate of 10.0 cents per $100
of deposits.  In the fourth quarter of 2008, the Company received
notification that FDIC was modifying its risk based assessment to incorporate
additional risk-based adjustments for unsecured and secured borrowings and for
institutions categorized in risk categories II, III, and IV, an adjustment for
brokered deposits beginning with assessment period starting on April 1,
2009.  The FDIC also announced that, beginning April 1, 2009, the base
assessment rate would increase for all risk categories before application of the
risk-based adjustments.  Additionally, the FDIC announced a uniform 7
basis point increase to the base assessment rate (before risk-based adjustments)
for the assessment period beginning on January 1, 2009.  Subsequent to
year-end, the Banks received notification the FDIC was imposing a one-time
special assessment of 20 basis points on June 30, 2009 and payable on September
30, 2009.   There has been continued debate about the amount of
the assessment subsequent to its announcement with the possibility existing that
the assessment may be lowered.  The effect of these changes by the
FDIC will result in a significant increase in the Company’s FDIC assessment
expense for 2009.  If the one time special assessment passes, the
Company estimates these changes will result in an increase in FDIC assessment
expense of $2.0 million in 2009 as compared to 2008 based on the current risk
ratings of the Banks and their deposit bases as of December 31,
2008.





The FDIC
may terminate the deposit insurance of any insured depository institution if it
determines, after a hearing, that the institution has engaged or is engaging in
unsafe or unsound practices, is in an unsafe or unsound condition to continue
operations or has violated any applicable law, regulation, order or any
condition imposed by an agreement with the FDIC.





The Federal Reserve System.
The Federal Reserve Board requires all depository institutions to maintain
reserves against their transaction accounts and non-personal time deposits. Cash
on hand or on deposit with the Federal Reserve Bank of $1.4 million was required
to meet regulatory reserve and clearing requirements at year-end 2008 and
2007.  In October 2008, the Federal Reserve began paying interest on
these balances.  Banks are authorized to borrow from the Federal
Reserve Bank "discount window," but Federal Reserve Board regulations require
banks to exhaust other reasonable alternative sources of funds, including FHLB
advances, before borrowing from the Federal Reserve Bank.





Federal Taxation. For federal
income tax purposes, the Company and its subsidiaries file a consolidated
federal income tax return on a calendar year basis. Consolidated returns have
the effect of eliminating intercompany distributions, including dividends, from
the computation of consolidated taxable income for the taxable year in which the
distributions occur.





The
Company and its subsidiaries are subject to the rules of federal income taxation
generally applicable to corporations under the Internal Revenue Code of 1986, as
amended (the "Code").





10
 Index


Management
has evaluated its tax positions in association with the adoption of FASB
Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an
interpretation of FASB Statement No. 109 (FIN 48), which prescribes a
recognition threshold and measurement attribute for a tax position taken or
expected to be taken in a tax return effective for its fiscal year beginning
January 1, 2007.  The adoption of FIN 48 did not have a material
effect upon adoption.  As of December 31, 2007, the Company’s 2004 and
2005 federal tax returns were being audited by the Internal Revenue Service
(“IRS”).  In 2008, the Company was notified by the IRS that the
examinations were complete and that there would be no adjustments made for 2004
and 2005 and a refund would be issued for 2006 for
$20,000.  Accordingly, the Company reduced its reserve for
unrecognized tax benefits in 2008 by $55,000.





Indiana Taxation. The Company
is subject to an income tax imposed by the State of Indiana.  The tax
is imposed at the rate of 8.5 percent of the Company's adjusted gross income. In
computing adjusted gross income, no deductions are allowed for municipal
interest and U.S. Government interest.  In 2000, the Indiana financial
institution tax law was amended to treat resident financial institutions the
same as nonresident financial institutions by providing for apportionment of
Indiana income based on receipts in Indiana. This revision allowed for the
exclusion of receipts from out of state sources and federal government and
agency obligations.





Currently,
income from YCB’s subsidiaries CBSI Holdings, Inc., CBSI Investments, Inc. and
CBSI Investment Portfolio Management, LLC is not subject to the Indiana income
tax.





The
Company’s December 31, 2004, 2003, and 2002 Indiana state income tax returns
were audited in 2006.  The Indiana Department of Revenue concluded
that no adjustments were necessary as a result of their audits.





Kentucky
Taxation.  The Company is subject to a franchise tax imposed by
the Commonwealth of Kentucky on its operations in Kentucky.  The tax
is imposed at a rate of 1.1% on taxable net capital, which equals capital stock
paid in, surplus, undivided profits and capital reserves, net unrealized holding
gains or losses on available for sale securities, and cumulative foreign
currency translation adjustments less an amount equal to the same percentage of
the total as the book value of United States obligations and Kentucky
obligations bears to the book value of the total assets of the financial
institution.  A financial institution whose business activity is
taxable within and without Kentucky must apportion its net capital based on the
three factor apportionment formula of receipts, property and payroll unless the
Kentucky Revenue Cabinet has granted written permission to use another
method.





Recent legislation affecting the
Company.In
response to recent market and economic conditions, the United States government,
particularly the U.S. Department of the Treasury (the “U.S. Treasury”), the
Board of Governors of the Federal Reserve System (the “Federal Reserve”) and the
Federal Deposit Insurance Corporation (the “FDIC”), have taken a variety of
extraordinary measures designed to provide fiscal stimulus, restore confidence
in the financial markets and to strengthen financial institutions, including
capital injections, guarantees of bank liabilities and the acquisition of
illiquid assets from banks. In particular on October 3, 2008 and
February 17, 2009, the Emergency Economic Stabilization Act of 2008 (the
“EESA”) and the American Recovery and Reinvestment Act of 2009 (the “ARRA”),
respectively, were signed into law.
























































11
 Index




Other
programs and actions taken include (1) the U.S. Treasury’s Temporary
Guarantee Program for Money Market Funds, which is designed to guarantee the
share price of eligible money market funds that apply to the program and pay a
fee to participate, (2) the Federal Reserve Bank of New York’s Money Market
Investor Funding Facility (the “MMIFF”), which is designed to provide liquidity
to U.S. money market investors, (3) the Federal Reserve’s Commercial Paper
Funding Facility, which is designed to provide liquidity to term funding markets
by providing a liquidity backstop to U.S. issuers of commercial paper, (4) the
Federal Reserve’s Asset Backed Commercial Paper Money Market Mutual Fund
Liquidity Facility (the “AML Facility”), which is designed to provide liquidity
to money market mutual funds under certain conditions by providing funding to
U.S. depository institutions and bank holding companies secured by high-quality
asset-backed commercial paper they purchased from those money market mutual
funds, (5) the FDIC’s Temporary Liquidity Guarantee Program (the “TLG Program”),
which enables the FDIC to temporarily provide a 100% guarantee of the senior
debt of all FDIC-insured institutions and their holding companies, as well as
deposits in noninterest-bearing transaction deposit accounts, (6) the Federal
Reserve’s Primary Dealer Credit Facility (the “PDCF”), which is designed to
foster the financial markets generally, was modified to expand the eligible
collateral to include any collateral eligible for tri-party repurchase
agreements, (7) the Federal Reserve’s Term Securities Lending Facility (the
“TSLF”), which is designed to promote liquidity in the financial markets for
treasuries and other collateral, was expanded to (a) include all
investment-grade debt securities as eligible collateral for schedule 2 auctions
and (b) increase the frequency of schedule 2 auctions, (8) the Federal
Reserve’s adoption of an interim rule that provides an exemption, until
January 30, 2009, to the Federal Reserve Act to allow insured depository
institutions to provide liquidity to their affiliates for assets typically
funded in the tri-party repurchase agreement market, (9) the Federal Reserve’s
Term Auction Facility (the “TAF”), which is designed to allow financial
institutions to borrow funds at a rate that is below the discount rate, (10) the
Federal Reserve’s Term Asset-Backed Securities Loan Facility (the “TALF”), which
is designed to assist in the credit markets in accommodating the credit needs of
consumers and small businesses by facilitating the issuance of asset-backed
securities and improving the conditions for asset-backed securities more
generally, (11) the Federal Reserve’s announcement that it will purchase up to
$600 billion of direct obligations of housing-related government–sponsored
enterprises (“GSEs”) and mortgage-backed securities of GSEs, (12) the U.S.
Treasury’s Financial Stability Plan, which involves (a) the creation of a
public-private investment fund of up to $1 trillion, (b) the expansion of the
TALF program up to $1 trillion under the consumer and business lending
initiative, and (c) the creation of a financial stability trust for bank
investment and additional transparency, and (13) President Obama’s Home Owner
Affordability and Stability Plan, which is intended to (a) provide
refinancing assistance for responsible homeowners suffering from falling home
prices, (b) a comprehensive $75 billion homeowner stability initiative, and
(c) strengthen confidence in the GSEs. The Company is currently
participating in certain of these programs and may become a future participant
in others of these programs, or additional new programs established by the
U.S. government.









Available
Information.  The Company files annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to
those reports with the Securities and Exchange Commission (“SEC”) pursuant to
Section 13(a) or 15(d) of the Securities Exchange Act of 1934.  The
public may read and copy any material the Company files with the SEC at the
SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549 and may
obtain information on the operation of the Public Reference Room by calling the
SEC at 1-800-SEC-0330.  The SEC maintains an Internet site that
contains reports, proxy and information statements, and other information
regarding issuers that file electronically with the SEC on its website at www.sec.gov.  The
Company makes available through its website, www.yourcommunitybank.com,
its annual report on Form 10-K, quarterly reports on Form 10-Q, and current
reports on Form 8-K.







Item
1A.  Risk Factors





There are
a number of factors, including those specified below, that may adversely affect
our business, financial results or stock price.  Additional risks that
we currently do not know about or currently view as immaterial may also impair
our business or adversely impact our financial results or stock
price.





As used
in this Item 1A of the Form 10-K, the terms “we”, “us” and “our” refer to Community Bank
Shares of Indiana, Inc., an Indiana corporation and its subsidiaries (unless the
context clearly implies otherwise).




















12
 Index





Industry
Risk Factors





Economic
Conditions.  Our earnings are affected by the general economic
conditions in the United States, and to a lesser extent, general international
economic conditions.  Economic conditions in the United States and
abroad deteriorated significantly in the latter part of 2008.  The
United States is currently in a recession.  The housing market is in
decline reflected by falling home prices and increases in
foreclosures.  Unemployment has increased.  These factors
have affected the performance of mortgage loans and resulted in financial
institutions, including government-sponsored entities, in making significant
write-downs of asset values of mortgage-backed securities, credit default swaps
and other derivative and cash securities.  Some financial institutions
have failed.  Many financial institutions and institutional investors
have tightened the availability of credit to borrowers and other financial
institutions, which, in turn, results in more loan defaults and decreased
business activity.  Consumer confidence regarding the economy is low
and the financial markets reflect this lack of confidence.  This
recession has adversely affected our business, financial condition, results of
operations, liquidity and access to capital and credit.  We do not
expect significant improvement in the economy in the near future, and future
declines in the economy will likely make the credit market crisis
worse.





Recent Regulations Regarding U.S.
Financial System.  In response to the economic downturn and
financial crisis, the U.S. government has enacted legislation by passing the
Emergency Economic Stabilization Act of 2008 (the “Stabilization Act”) followed
by the American Recovery and Reinvestment Act of 2009 (the “Recovery
Act”).  These Acts have enabled the U.S. Treasury, the FDIC and the
Federal Reserve Board to develop programs, such as the TARP Capital Purchase
Program, the Financial Stability Plan and the foreclosure prevention program, to
improve funding to consumers, increase interbank lending and reduce home
foreclosures.  The U.S. government continues to closely evaluate the
economy, the effect of its legislation and resulting programs and initiatives on
the economy.  We expect that the U.S. government will continue to
refine these programs and develop new programs.  We do not know
whether these Acts and programs will positively affect the economy, help
stabilize the financial markets and increase the availability of
credit.  Our business, financial condition, results of operations,
liquidity and access to capital and credit will likely be negatively affected If
the economy worsens or the financial markets do not stabilize.





Changes in the laws, regulations and
policies governing financial services companies could alter our business
environment and adversely affect our operations.The Board of
Governors of the Federal Reserve System regulates the supply of money and credit
in the United States. Its fiscal and monetary policies determine in a large part
our cost of funds for lending and investing and the return that can be earned on
those loans and investments, both of which affect our net interest margin.
Federal Reserve Board policies can also materially affect the value of financial
instruments that we hold, such as debt securities.





We, along with our subsidiaries, are
heavily regulated at the federal and state levels. This regulation is to protect
depositors, federal deposit insurance funds and the banking system as a
whole.Congress and state legislatures and federal and state
agencies continually review banking laws, regulations and policies for possible
changes. Changes in statutes, regulations or policies could affect us in
substantial and unpredictable ways, including limiting the types of financial
services and products that we offer and/or increasing the ability of non-banks
to offer competing financial services and products. We cannot predict whether
any of this potential legislation will be enacted, and if enacted, the effect
that it or any regulations would have on our financial condition or results of
operations.





The financial services industry is
highly competitive, and competitive pressures could intensify and adversely
affect our financial results.We operate in a highly competitive industry
that could become even more competitive as a result of legislative, regulatory
and technological changes and continued consolidation. We compete with other
commercial banks, savings and loan associations, mutual savings banks, finance
companies, mortgage banking companies, credit unions and investment companies.
In addition, technology has lowered barriers to entry and made it possible for
non-banks to offer products and services traditionally provided by banks. Many
of our competitors have fewer regulatory constraints and some have lower cost
structures. Also, the potential need to adapt to industry changes in information
technology systems, on which we and the financial services industry are highly
dependent, could present operational issues and require capital
spending.





Changes in consumer use of banks and
changes in consumer spending and saving habits could adversely affect our
financial results.Technology and other changes now allow many
consumers to complete financial transactions without using banks. For example,
consumers can pay bills and transfer funds directly without going through a
bank. This “disintermediation” could result in the loss of fee income, as well
as the loss of customer deposits and income generated from those deposits. In
addition, changes in consumer spending and saving habits could adversely affect
our operations, and we may be unable to timely develop competitive new products
and services in response to these changes that are accepted by new and existing
customers.






13
 Index




Risks associated with unpredictable
economic and political conditions may be amplified as a result of our limited
market area.Commercial banks and other financial institutions are
affected by economic and political conditions, both domestic and international,
and by governmental monetary policies. Conditions such as inflation, value of
the dollar, recession, unemployment, high interest rates, short money supply,
scarce natural resources, international disorders, terrorism and other factors
beyond our control may adversely affect profitability. In addition, almost all
of our primary business area is located in Southern Indiana and Jefferson
County, Kentucky. A significant downturn in this regional economy may result in,
among other things, deterioration in our credit quality or a reduced demand for
credit and may harm the financial stability of our customers. Due to the
regional market area, these negative conditions may have a more noticeable
effect on us than would be experienced by an institution with a larger, more
diverse market area.





Changes in the domestic interest
rate environment could reduce our net interest income.Interest rate volatility
could significantly harm our business. Our results of operations are affected by
the monetary and fiscal policies of the federal government and the regulatory
policies of governmental authorities. A significant component of earnings is net
interest income, which is the difference between the income from
interest-earning assets, such as loans, and the expense of interest-bearing
liabilities, such as deposits. A change in market interest rates could adversely
affect earnings if market interest rates change such that the interest we pay on
deposits and borrowings increases faster than the interest we collect on loans
and investments. Consequently, along with other financial institutions
generally, we are sensitive to interest rate fluctuations.





Company
Risk Factors





Our allowance for loan losses may
not be adequate to cover actual losses.  Like all financial
institutions, we maintain an allowance for loan losses to provide for loan
defaults and non-performance. Our allowance for loan losses is based on our
historical loss experience as well as an evaluation of the risks associated with
our loan portfolio, including the size and composition of the loan portfolio,
loan portfolio performance, current economic conditions and geographic
concentrations within the portfolio. Our allowance for loan losses may not be
adequate to cover actual loan losses, and future provisions for loan losses
could materially and adversely affect its financial results.





We may suffer losses in our loan
portfolio despite our underwriting practices.Our results of
operations are significantly affected by the ability of borrowers to repay their
loans. Lending money is an essential part of the banking business. However,
borrowers do not always repay their loans. The risk of non-payment is
historically small, but if nonpayment levels are greater than anticipated, our
earnings and overall financial condition, as well as the value of our common
stock, could be adversely affected. No assurance can be given that our
underwriting practices or monitoring procedures and policies will reduce certain
lending risks.   Loan losses can cause insolvency and failure of
a financial institution and, in such an event, our stockholders could lose their
entire investment. In addition, future provisions for loan losses could
materially and adversely affect profitability. Furthermore, the application of
various federal and state laws, including bankruptcy and insolvency laws, may
limit the amount that can be recovered on these loans.





Maintaining or increasing our market
share may depend on lowering prices and market acceptance of new products and
services. Our success depends, in part, on our ability to adapt our
products and services to evolving industry standards. There is increasing
pressure to provide products and services at lower prices. Lower prices can
reduce our net interest margin and revenues from our fee-based products and
services. In addition, the widespread adoption of new technologies, including
internet services, could require us to make substantial expenditures to modify
or adapt our existing products and services. Also, these and other capital
investments in our businesses may not produce expected growth in earnings
anticipated at the time of the expenditure. We might not be successful in
introducing new products and services, achieving market acceptance of its
products and services, or developing and maintaining loyal
customers.





Because the nature of the financial
services business involves a high volume of transactions, we face significant
operational risks.   Operational risk is the risk of loss
resulting from our operations, including, but not limited to, the risk of fraud
by employees or persons outside of the Company, the execution of unauthorized
transactions by employees, errors relating to transaction processing and
technology, breaches of the internal control system and compliance requirements
and business continuation and disaster recovery. This risk of loss also includes
the potential legal actions that could arise as a result of an operational
deficiency or as a result of noncompliance with applicable regulatory standards,
adverse business decisions or their implementation, and customer attrition due
to potential negative publicity. In the event of a breakdown in the internal
control system, improper operation of systems or improper employee actions, we
could suffer financial loss, face regulatory action and suffer damage to its
reputation.











14
 Index




Acquisitions and the addition of
branch facilities may not produce revenue enhancements or cost savings at levels
or within timeframes originally anticipated and may result in unforeseen
integration difficulties.We regularly explore
opportunities to establish branch facilities and acquire other banks or
financial institutions.  New or acquired branch facilities and other
facilities may not be profitable. We may not be able to correctly identify
profitable locations for new branches. The costs to start up new branch
facilities or to acquire existing branches, and the additional costs to operate
these facilities, may increase our noninterest expense and decrease earnings in
the short term. It may be difficult to adequately and profitably manage growth
through the establishment of these branches. In addition, we can provide no
assurance that these branch sites will successfully attract enough deposits to
offset the expenses of operating these branch sites. Any new or acquired
branches will be subject to regulatory approval, and there can be no assurance
that we will succeed in securing such approvals.





We cannot
predict the number, size or timing of acquisitions. Difficulty in integrating an
acquired business or company may cause us not to realize expected revenue
increases, cost savings, increases in geographic or product presence, and/or
other projected benefits from the acquisition. The integration could result in
higher than expected deposit attrition (run-off), loss of key employees,
disruption of our business or the business of the acquired company, or otherwise
adversely affect our ability to maintain relationships with customers and
employees or achieve the anticipated benefits of the acquisition. Also, the
negative effect of any divestitures required by regulatory authorities in
acquisitions or business combinations may be greater than expected.





Our business could suffer if we fail
to attract and retain skilled people.Our
success depends, in large part, on our ability to attract and retain key people.
Competition can be intense for the best people in most activities in which we
engage. We may not be able to hire the best people or to keep them.





Significant legal actions could
subject us to substantial uninsured liabilities.We are from time
to time subject to claims related to our operations. These claims and legal
actions, including supervisory actions by our regulators, could involve large
monetary claims and significant defense costs. To protect us from the cost of
these claims, we maintain insurance coverage in amounts and with deductibles
that we believe are appropriate for our operations. However, our insurance
coverage may not cover all claims against us or continue to be available to us
at a reasonable cost. As a result, we may be exposed to substantial uninsured
liabilities, which could adversely affect our results of operations and
financial condition.





We are exposed to risk of
environmental liability when we take title to properties.  In
the course of our business, we may foreclose on and take title to real estate.
As a result, we could be subject to environmental liabilities with respect to
these properties. We may be held liable to a governmental entity or to third
parties for property damage, personal injury, investigation and clean-up costs
incurred by these parties in connection with environmental contamination or may
be required to investigate or clean up hazardous or toxic substances or chemical
releases at a property. The costs associated with investigation or remediation
activities could be substantial. In addition, if we are the owner or former
owner of a contaminated site, we may be subject to common law claims by third
parties based on damages and costs resulting from environmental contamination
emanating from the property. If we become subject to significant environmental
liabilities, our financial condition and results of operations could be
adversely affected.





Our stock price can be volatile and
there is a limited trading market for our stock.Our stock price can
fluctuate widely in response to a variety of factors, including:





§
            actual
      or anticipated variations in our quarterly operating
    results;


§
            recommendations
      by securities analysts; acquisitions or business
    combinations;


§
            operating
      and stock price performance of other companies that investors deem
      comparable to us;


§
            new
      technology used or services offered by our
  competitors;


§
            news
      reports relating to trends, concerns and other issues in the financial
      services industry; and


§
            changes
      in government regulations.





General
market fluctuations, industry factors and general economic and political
conditions and events, including terrorist attacks, economic slowdowns or
recessions, interest rate changes, credit loss trends or currency fluctuations,
could also cause our stock price to decrease regardless of our operating
results.














15
 Index





In
addition, there is a limited trading market for our common stock and
shareholders may not be able to resell shares at or above the price paid for
them. The price of the common stock purchased may decrease significantly.
Although our common stock is quoted on the Nasdaq Capital Market under the
symbol "CBIN", trading activity in the stock historically has been sporadic. A
public trading market having the desired characteristics of liquidity and order
depends on the presence in the market of willing buyers and sellers at any given
time. The presence of willing buyers and sellers depends on the individual
decisions of investors and general economic conditions, all of which are beyond
our control.





Our historical growth rates may not
be sustainable.We
may not be able to maintain and manage our growth, which may adversely affect
our results of operations and financial condition and the value of our common
stock. We cannot assure you that we will continue to be successful in increasing
the volume of loans and deposits at acceptable risk levels and upon acceptable
terms.  Additionally, we may not continue to be successful in
expanding our asset base to a targeted size and managing the costs and
implementation risks associated with our growth strategy. We cannot assure you
that further expansion will be profitable or that our historical rate of growth
will continue to be sustained, either through internal growth or otherwise, or
that capital will be maintained sufficient to support continued growth.
Furthermore, if we grow too quickly and are not able to control costs and
maintain asset quality, rapid growth also could adversely affect our financial
performance.





We rely on dividends from our
subsidiaries for our liquidity needs.  Our holding company
status makes us dependent on dividends from our subsidiaries to meet our
obligations. We do not have any significant assets other than cash and the stock
of our subsidiaries. Accordingly, we depend on dividends from our subsidiaries
(and, in turn, their subsidiaries) to meet our obligations and obtain revenue.
Our right to participate in any distribution of earnings or assets of our
subsidiaries is subject to the prior claims of creditors of our subsidiaries.
Under federal and state law, our subsidiaries are limited in the amount of
dividends they may pay to us without prior regulatory approval. Also, bank
regulators have the authority to prohibit our subsidiaries from paying dividends
if the bank regulators determine the payment would be an unsafe and unsound
banking practice.





Our ability to pay dividends on our
common stock is limited.We
cannot assure you that we will continue to pay dividends at our current annual
dividend rate or at all. In particular, the ability to pay dividends in the
future will depend upon, among other things, our future earnings and cash
requirements.





Our FDIC Insurance Assessment could
significantly
increase.  On  February  27,  2009,  the  FDIC
approved an interim rule to institute a
one-time  special  emergency  assessment  of  20
cents per $100 in domestic
deposits  on  June  30,  2009,  to  be  collected
by September 30, 2009, to restore the Deposit Insurance Fund (“DIF”) reserves
depleted by recent bank failures.  The interim rule also permits the
FDIC to impose an additional special emergency assessment after June 30, 2009 of
up-to-10 basis points, if necessary. The FDIC also adopted amendments to its
restoration plan for the DIF.  The amendments changes to the
risk-based assessment system and set assessment rates to require most banks to
initial base rates ranging from 12 cents per $100 to 16 cents per $100 on an
annual basis, beginning on April 1, 2009.  The amendments also change
the assessment system include higher
rates  for  institutions  that  rely  significantly
on secured liabilities,
which  may  increase  the  FDIC’s  loss  in  the  event  of
failure without
providing  additional  assessment  revenue.
Assessments will also be higher for institutions that rely significantly on
brokered deposits but, for well-managed and well-capitalized institutions, only
when accompanied by rapid asset growth. Based on our budgeted deposit levels,
the final approval of this interim rule and the increase of the quarterly
assessments would impact the Company by increasing FDIC Insurance Assessment
expense by approximately $2.0 million. Our projection will vary to the extent
actual deposit levels fluctuate compared to budget.  There has been
continued debate about the amount of the assessment subsequent to it its
announcement with the possibility existing that the assessment may be
lowered.  Should the assessment be lowered, our estimate of the
increase in FDIC assessment expense for 2009 will be lowered as
well.


Other-than-temporary
impairment.  Our investment portfolio has approximately $3.0
million of unrealized losses as of December 31, 2008.  While we have
evaluated each security with an unrealized loss for other-than-temporary
impairment under the applicable accounting guidance and concluded that an
impairment loss should not be recorded, we cannot assure you that we will not
need to record an impairment loss in the future.  Should there be
deterioration in the credit quality and/or the severity and length of the
underlying unrealized losses in our portfolio in the future, we may be required
to record an impairment charge that could significantly impact our earnings and
capital ratios.

















16
 Index




Goodwill
impairment.  We currently have $15.3 million of goodwill
reported as an asset on our balance sheet associated with our acquisition of
SCSB for which we are required to at least annually to evaluate for
impairment.  We have determined that our goodwill is not impaired and
have not recorded a charge through earnings.  We cannot assure you
that we will not need to record a goodwill impairment charge in the future if
market conditions do not improve and our stock price does not
increase.  Also, if the Company’s profitability does not improve, our
stock price may decline further which may lead to an increase in the possibility
of a goodwill impairment charge.  Should we have to record a goodwill
impairment charge in the future, our earnings could possibly be significantly
impacted.





Item 1B.  Unresolved Staff
Comments





This item
of Form 10-K is inapplicable to the Company inasmuch as it is not an accelerated
filer or large accelerated filer, nor is it a well-known seasoned
issuer.  Moreover, the Company has received no written communication
from the staff of the SEC regarding its periodic or current reporting under the
Exchange Act.





17
 Index


Item
2.  Properties





The
Company conducts its business through its corporate headquarters located in New
Albany, Indiana.  YCB operates a main office and eleven branch offices
in Clark and Floyd Counties, Indiana, and six branch offices in Jefferson and
Nelson Counties, Kentucky. SCSB operates a main office and three branch offices
in Scott County, Indiana.  The following table sets forth certain
information concerning the main offices and each branch office at December 31,
2008. The Company’s aggregate net book value of premises and equipment was $15.1
million at December 31, 2008.





Location
                      Year Opened
                      Owned or LeasedYour
      Community Bank:101
      West Spring Street - Main Office
                      1937
                      OwnedNew
      Albany, IN  47150401
      East Spring Street - Drive Thru for Main Office
                      2001
                      OwnedNew
      Albany, IN  471502626
      Charlestown Road
                      1995
                      OwnedNew
      Albany, IN  471504328
      Charlestown Road
                      2004
                      LeasedNew
      Albany, IN 47150480
      New Albany Plaza
                      1974
                      LeasedNew
      Albany, IN 47130901
      East Highway 131
                      1981
                      OwnedClarksville,
      IN  47130701
      Highlander Point Drive
                      1990
                      OwnedFloyds
      Knobs, IN  47119102
      Heritage Square
                      1992
                      OwnedSellersburg,
      IN  47172201
      W. Court Avenue
                      1996
                      OwnedJeffersonville,
      IN 47105112
      Highway 62
                      1997
                      OwnedJeffersonville,
      IN  471302917
      E. 10th
      Street
                      2007
                      LeasedJeffersonville,
      IN 471302910
      Grantline Road
                      2002
                      LeasedNew
      Albany, IN  47150400
      Blankenbaker Parkway, Suite 100
                      2002
                      LeasedLouisville,
      KY 40243106A
      West John Rowan Boulevard. - Main Office
                      1997
                      LeasedBardstown,
      KY 40004119
      East Stephen Foster Avenue
                      1972
                      OwnedBardstown,
      KY 400047101
      Cedar Springs
                      2002
                      LeasedLouisville,
      KY 402914510
      Shelbyville Road
                      2003
                      LeasedLouisville,
      KY 4020713205
      Magisterial Drive
                      2006
                      LeasedLouisville,
      KY 40223471
      West Main Street
                      2008
                      LeasedLouisville,
      KY 40202The
      Scott County State Bank:136
      West McClain Avenue - Main Office
                      1890
                      OwnedScottsburg,
      IN  47170125
      West Wardell - Drive Thru
                      1981
                      OwnedScottsburg,
      IN  471701050
      North Gardner
                      1974
                      OwnedScottsburg,
      IN  4717057
      North Michael Drive
                      1998
                      OwnedScottsburg,
      IN 47170





18
 Index




Item
3.  Legal Proceedings





There are
various claims and law suits in which the Company or its subsidiaries are
periodically involved, such as claims to enforce liens, foreclosure or
condemnation proceedings on properties in which the Banks hold mortgages or
security interests, claims involving the making and servicing of real property
loans and other issues incident to the Banks’ business. In the opinion of
management, no material loss is expected from any of such pending claims or
lawsuits with the possible exception of the following matter.





YCB made
loans to borrower MW Development Services, LLC (“Borrower”) beginning in
September, 2004, guaranteed by the borrower’s two principals.  The
loans were to enable the borrower to purchase real estate and develop it for
sale as residential subdivision lots.  The loans are secured by first
and second mortgage liens in favor of YCB on the real property.  The
borrower defaulted on the loans and in July 2005 D.F. Crane Construction Corp.
(“Crane”) filed a foreclosure action on its mechanic’s lien in the Jefferson
Circuit Court (Commonwealth of Kentucky) naming the borrower and YCB defendants,
among others.  YCB, borrower and guarantors asserted claims against
each other, which were settled by agreement in 2006.  Crane
subsequently sought to subordinate YCB’s mortgages to its lien claim but during
2008 YCB and Crane settled Crane’s claims and those of the contractors claiming
through it.





The Court entered a judgment
and an order of sale in favor of YCB, which was the successful bidder at the
September 23, 2008 foreclosure sale, purchasing the real property with a credit
bid of $1,500,000.  YCB has moved the Court to confirm the Master
Commissioner's September 26, 2008 Report of Sale and to direct the Master
Commissioner to deliver a deed conveying title to it.  The Court has
referred this motion to the Master Commissioner's Office and YCB and the Master
Commissioner are in the process finalizing the deed conveying the real property
to YCB.










Item
4.  Submission Of Matters To A Vote Of Security
Holders





No matter
was submitted to a vote of security holders, through the solicitation of proxies
or otherwise, during the quarter ended December 31, 2008.





19
 Index


Part II





Item
5.  Market For Registrant’s Common Equity, Related Stockholder Matters
And Issuer Purchases of Equity Securities





Market
Information


The
Company’s common stock is traded on the Nasdaq National Market under the symbol
“CBIN”.  The quarterly range of low and high trade prices per share of
the Company’s common stock for the periods indicated as reported on the Nasdaq
National Market, as well as the per share dividend paid in each such quarter by
the Company on its common stock is shown below.


2008
                                                                                                                                              
                                                                                                                                              2007QUARTER ENDED
                                                                                                                                              
                                                                                                                                              HIGH
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              LOW
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              DIVIDEND
                                                                                                                                              
                                                                                                                                              QUARTER ENDED
                                                                                                                                              
                                                                                                                                              HIGH
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              LOW
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              DIVIDENDMarch
      31
                                                                                                                                              
                                                                                                                                              $
                                                                                                                                              20.50
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              $
                                                                                                                                              17.75
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              $
                                                                                                                                              0.175
                                                                                                                                              
                                                                                                                                              March
      31
                                                                                                                                              
                                                                                                                                              $
                                                                                                                                              22.99
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              $
                                                                                                                                              21.44
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              $
                                                                                                                                              0.160June
      30
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              20.00
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              15.16
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              0.175
                                                                                                                                              
                                                                                                                                              June
      30
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              21.85
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              19.74
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              0.175September
      30
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              17.06
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              11.05
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              0.175
                                                                                                                                              
                                                                                                                                              September
      30
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              21.45
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              19.25
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              0.175December
      31
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              15.50
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              10.37
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              0.175
                                                                                                                                              
                                                                                                                                              December
      31
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              21.35
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              17.30
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              
                                                                                                                                              0.175
   Holders


As of
March 19, 2009 there were 870 holders of the Company’s common
stock.





Dividends


The
Company intends to continue its historical practice of paying quarterly cash
dividends although there is no assurance that such dividends will continue to be
paid in the future.  The payment of dividends in the future is
dependent on future income, financial position, capital requirements, the
discretion and judgment of the Board of Directors, and other
considerations.  In addition, the payment of dividends is subject to
the regulatory restrictions described in Note 14 to the Company's consolidated
financial statements.








Securities
Authorized for Issuance under Equity Compensation Plans


The
following table sets forth certain information regarding Company compensation
plans under which equity securities of the Company are authorized for
issuance.








Number
      of
                    Securities
      to be
                    Issued
      Upon Exercise of Outstanding Options,
                    Warrants and Rights
                  
                  
                  Weighted-Average
                    Exercise
      Price Of
                    Outstanding
      Options,
                    Warrants and Rights
                  
                  
                  Number
      of Securities
                    Remaining
      Available for Future Issuance under equity compensation plans
                    (excluding
      securities
                    reflected in column 1)Equity
      compensation plans approved by security holders
                  
                  
                  277,595
                  (1)
                  
                  $
                  20.56
                  
                  
                  
                  450,450
                  (2)Equity
      compensation plans not   approved by security
      holders
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Total
                  
                  
                  277,595
                  (1)
                  
                  $
                  20.56
                  
                  
                  
                  450,450
                  (2)








(1) Of
the shares reflected, 262,970 shares have been granted under the Company’s Stock
Award Plan and 22,500 performance units have been granted under the Company’s
Performance Units Plan of which 14,625, or 65%, will be paid in shares (see Note
11 of the Company’s consolidated financial statements for further information on
the Company’s Performance Units Plan).  The awards under the Company’s
Performance Units Plan have been excluded from the weighted-average exercise
price column.


(2) Of
the shares reflected, 197,550 shares are available to be awarded under the
Company’s Stock Award Plan and 252,900 shares are available to be awarded under
the Company’s Performance Units Plan.














20
 Index




Performance
Graph





The
following performance graph and included data shall not be deemed filed for
purposes of Section 18 of the Securities Exchange Act of 1934 or otherwise
subject to the liabilities of that section, nor shall it be deemed soliciting
material or subject to Regulation 14A of the Exchange Act or incorporated by
reference in any filing under the Exchange Act or the Securities Act of 1933,
except as shall be expressly set forth by specific reference in such
filing.





The graph
compares the performance of Community Bank Shares of Indiana, Inc. common stock
to the Russell 2000 index and the SNL Bank $500 MM - $1 B Bank index for the
Company’s last five fiscal years.  The graph assumes the value of the
investment in Company common stock and in each index was $100 at December 31,
2003 and that all dividends were reinvested.








Period
      EndingIndex
                      
                      12/31/03
                      
                      
                      12/31/04
                      
                      
                      12/31/05
                      
                      
                      12/31/06
                      
                      
                      12/31/07
                      
                      
                      12/31/08Community
      Bank Shares of Indiana, Inc.
                      
                      
                      100.00
                      
                      
                      
                      108.82
                      
                      
                      
                      118.94
                      
                      
                      
                      120.77
                      
                      
                      
                      98.63
                      
                      
                      
                      68.08Russell
      2000
                      
                      
                      100.00
                      
                      
                      
                      118.33
                      
                      
                      
                      123.72
                      
                      
                      
                      146.44
                      
                      
                      
                      144.15
                      
                      
                      
                      95.44SNL
      Bank $500M-$1B Index
                      
                      
                      100.00
                      
                      
                      
                      113.32
                      
                      
                      
                      118.18
                      
                      
                      
                      134.41
                      
                      
                      
                      107.71
                      
                      
                      
                      69.02











21
 Index


Item
6.  Selected Financial Data





The
following table sets forth the Company’s selected historical consolidated
financial information from 2004 through 2008.  This information should
be read in conjunction with the Consolidated Financial Statements and the
related Notes.  Factors affecting the comparability of certain
indicated periods are discussed in "Management’s Discussion And Analysis Of
Financial Condition And Results Of Operations."  For analytical
purposes, net interest margin is adjusted to a taxable equivalent adjustment
basis to recognize the income tax savings on tax-exempt assets, such as state
and municipal securities.  A tax rate of 34% was used in adjusting
interest on tax-exempt assets to a fully taxable equivalent (“FTE”)
basis.





Years Ended December 31,(Dollars in thousands, except per share
      data)
                      
                      2008
                      
                      
                      2007
                      
                      
                      2006
                      
                      
                      2005
                      
                      
                      2004Income
      Statement Data:Interest
      income
                      
                      $
                      44,907
                      
                      
                      $
                      51,776
                      
                      
                      $
                      47,094
                      
                      
                      $
                      35,220
                      
                      
                      $
                      27,009Interest
      expense
                      
                      
                      21,453
                      
                      
                      
                      28,395
                      
                      
                      
                      25,995
                      
                      
                      
                      17,344
                      
                      
                      
                      12,796Net
      interest income
                      
                      
                      23,454
                      
                      
                      
                      23,381
                      
                      
                      
                      21,099
                      
                      
                      
                      17,876
                      
                      
                      
                      14,213Provision
      for loan losses
                      
                      
                      6,857
                      
                      
                      
                      1,296
                      
                      
                      
                      262
                      
                      
                      
                      1,750
                      
                      
                      
                      1,105Non-interest
      income
                      
                      
                      6,087
                      
                      
                      
                      4,127
                      
                      
                      
                      3,733
                      
                      
                      
                      4,703
                      
                      
                      
                      4,048Non-interest
      expense
                      
                      
                      22,554
                      
                      
                      
                      21,804
                      
                      
                      
                      19,116
                      
                      
                      
                      16,155
                      
                      
                      
                      13,903Income
      before taxes
                      
                      
                      130
                      
                      
                      
                      4,408
                      
                      
                      
                      5,454
                      
                      
                      
                      4,674
                      
                      
                      
                      3,253Net
      income
                      
                      
                      821
                      
                      
                      
                      3,503
                      
                      
                      
                      4,111
                      
                      
                      
                      3,749
                      
                      
                      
                      2,588Balance
      Sheet Data:Total
      assets
                      
                      $
                      877,363
                      
                      
                      $
                      823,568
                      
                      
                      $
                      816,633
                      
                      
                      $
                      665,008
                      
                      
                      $
                      590,066Total
      securities
                      
                      
                      121,659
                      
                      
                      
                      99,465
                      
                      
                      
                      121,311
                      
                      
                      
                      98,835
                      
                      
                      
                      90,152Total
      loans, net
                      
                      
                      623,103
                      
                      
                      
                      629,732
                      
                      
                      
                      607,932
                      
                      
                      
                      512,448
                      
                      
                      
                      450,676Allowance
      for loan losses
                      
                      
                      9,478
                      
                      
                      
                      6,316
                      
                      
                      
                      5,654
                      
                      
                      
                      5,920
                      
                      
                      
                      4,523Total
      deposits
                      
                      
                      603,185
                      
                      
                      
                      573,346
                      
                      
                      
                      549,918
                      
                      
                      
                      464,836
                      
                      
                      
                      411,306Other
      borrowings
                      
                      
                      78,983
                      
                      
                      
                      72,796
                      
                      
                      
                      84,335
                      
                      
                      
                      47,735
                      
                      
                      
                      43,629FHLB
      advances
                      
                      
                      111,943
                      
                      
                      
                      91,376
                      
                      
                      
                      92,756
                      
                      
                      
                      98,000
                      
                      
                      
                      82,000Subordinated
      debenture
                      
                      
                      17,000
                      
                      
                      
                      17,000
                      
                      
                      
                      17,000
                      
                      
                      
                      7,000
                      
                      
                      
                      7,000Total
      shareholders’ equity
                      
                      
                      62,599
                      
                      
                      
                      64,465
                      
                      
                      
                      65,541
                      
                      
                      
                      42,775
                      
                      
                      
                      42,781Per
      Share Data:Basic
      earnings per share
                      
                      $
                      0.25
                      
                      
                      $
                      1.05
                      
                      
                      $
                      1.36
                      
                      
                      $
                      1.43
                      
                      
                      $
                      0.98Diluted
      earnings per share
                      
                      
                      0.25
                      
                      
                      
                      1.04
                      
                      
                      
                      1.35
                      
                      
                      
                      1.41
                      
                      
                      
                      0.97Book
      value
                      
                      
                      19.31
                      
                      
                      
                      19.77
                      
                      
                      
                      19.06
                      
                      
                      
                      16.42
                      
                      
                      
                      16.27Cash
      dividends per share
                      
                      
                      0.700
                      
                      
                      
                      0.685
                      
                      
                      
                      0.640
                      
                      
                      
                      0.580
                      
                      
                      
                      0.540Performance
      Ratios:Return
      on average assets
                      
                      
                      0.10
                      %
                      
                      
                      0.43
                      %
                      
                      
                      0.55
                      %
                      
                      
                      0.59
                      %
                      
                      
                      0.47
                      %Return
      on average equity
                      
                      
                      1.29
                      
                      
                      
                      5.39
                      
                      
                      
                      7.73
                      
                      
                      
                      8.68
                      
                      
                      
                      6.10Net
      interest margin
                      
                      
                      3.09
                      
                      
                      
                      3.16
                      
                      
                      
                      3.04
                      
                      
                      
                      3.00
                      
                      
                      
                      2.74Efficiency
      ratio
                      
                      
                      76.35
                      
                      
                      
                      79.26
                      
                      
                      
                      76.98
                      
                      
                      
                      71.55
                      
                      
                      
                      76.13Asset
      Quality Ratios:Non-performing
      assets to total loans
                      
                      
                      3.45
                      %
                      
                      
                      1.88
                      %
                      
                      
                      0.98
                      %
                      
                      
                      1.08
                      %
                      
                      
                      0.37
                      %Net
      loan charge-offs to average loans
                      
                      
                      0.58
                      
                      
                      
                      0.10
                      
                      
                      
                      0.22
                      
                      
                      
                      0.07
                      
                      
                      
                      0.15Allowance
      for loan losses to total loans
                      
                      
                      1.50
                      
                      
                      
                      0.99
                      
                      
                      
                      0.92
                      
                      
                      
                      1.14
                      
                      
                      
                      0.99Allowance
      for loan losses to
                        non-performing
      loans
                      
                      
                      46
                      
                      
                      
                      56
                      
                      
                      
                      102
                      
                      
                      
                      108
                      
                      
                      
                      285Capital
      Ratios:Leverage
      ratio
                      
                      
                      7.6
                      %
                      
                      
                      8.0
                      %
                      
                      
                      8.1
                      %
                      
                      
                      8.0
                      %
                      
                      
                      8.7
                      %Average
      stockholders’ equity to average  total assets
                      
                      
                      7.6
                      
                      
                      
                      8.0
                      
                      
                      
                      7.1
                      
                      
                      
                      6.8
                      
                      
                      
                      7.7Tier
      1 risk-based capital ratio
                      
                      
                      9.5
                      
                      
                      
                      9.9
                      
                      
                      
                      10.5
                      
                      
                      
                      9.5
                      
                      
                      
                      10.4Total
      risk-based capital ratio
                      
                      
                      10.7
                      
                      
                      
                      10.9
                      
                      
                      
                      11.4
                      
                      
                      
                      10.5
                      
                      
                      
                      11.3Dividend
      payout ratio
                      
                      
                      277.2
                      
                      
                      
                      65.6
                      
                      
                      
                      46.7
                      
                      
                      
                      40.5
                      
                      
                      
                      54.8Other
      Key Data:End-of-period
      full-time equivalent employees
                      
                      
                      238
                      
                      
                      
                      232
                      
                      
                      
                      224
                      
                      
                      
                      182
                      
                      
                      
                      169Number
      of bank offices
                      
                      
                      23
                      
                      
                      
                      22
                      
                      
                      
                      21
                      
                      
                      
                      16
                      
                      
                      
                      16


22
 Index


Item
7.  Management’s Discussion And Analysis Of Financial Condition And
Results of Operations





Overview





This
section presents an analysis of the consolidated financial condition of the
Company and its wholly-owned subsidiaries, the Banks, at December 31, 2008 and
2007, and the consolidated results of operations for each of the years in the
three year period ended December 31, 2008.  The information contained
in this section should be read in conjunction with the consolidated financial
statements, notes to consolidated financial statements and other financial data
presented elsewhere in this annual report on Form 10-K.





The
Company conducts its primary business through the Banks, which are
community-oriented financial institutions offering a variety of financial
services to its local communities.  The Banks are engaged primarily in
the business of attracting deposits from the general public and using such funds
for the origination of: 1) commercial business and real estate loans and 2)
secured consumer loans such as home equity lines of credit, automobile loans,
and recreational vehicle loans.  Additionally, YCB originates and
sells into the secondary market mortgage loans for the purchase of single-family
homes in Floyd and Clark counties, Indiana, and Jefferson and Nelson counties,
Kentucky, including surrounding communities.  The Banks invest excess
liquidity balances in mortgage-backed, U.S. agency, state and municipal and
corporate securities.





The
operating results of the Company depend primarily upon the Banks’ net interest
income, which is the difference between interest earned on interest-earning
assets and interest incurred on interest-bearing
liabilities.  Interest-earning assets principally consist of loans,
taxable and tax-exempt securities, and FHLB stock.  Interest-bearing
liabilities principally include deposits, retail repurchase agreements, federal
funds purchased, and advances from the FHLB Indianapolis and
Cincinnati.  The net income of the Banks is also affected by 1)
provision for loan losses, 2) non-interest income (including mortgage banking
income, net gains on sales of securities, deposit account service charges and
commission-based income on non-deposit investment products), 3) non-interest
expenses (including compensation and benefits, occupancy, equipment, data
processing expenses, marketing and advertising, and other expenses, such as
audit, postage, printing, and telephone expenses), and 4) income tax
expense.





Forward
Looking Information





Statements
contained within this report that are not statements of historical fact
constitute forward-looking statements within the meaning of Section 21E of the
Securities Exchange Act of 1934.  When used in this discussion the
words "anticipate,"  "project,"  "expect," "believe," and
similar expressions are intended to identify forward-looking
statements.  The Company cautions that these forward-looking
statements are subject to numerous assumptions, risks and uncertainties, all of
which may change over time.  Actual results could differ materially
from forward-looking statements.





In
addition to factors disclosed by the Company elsewhere in this annual report on
Form 10-K, the following factors, among others, could cause actual results to
differ materially from such forward-looking statements: 1) adverse changes in
economic conditions affecting the banking industry in general and, more
specifically, the market areas in which the Company and its subsidiary Banks
operate, 2) adverse changes in the legislative and regulatory environment
affecting the Company and its subsidiary Banks, 3) increased competition from
other financial and non-financial institutions, 4) the impact of technological
advances on the banking industry, and 5) other risks detailed at times in the
Company’s filings with the Securities and Exchange Commission.  The
Company does not assume an obligation to update or revise any forward-looking
statements subsequent to the date on which they are made.





























23
 Index




Application
of Critical Accounting Policies





The
Company's consolidated financial statements are prepared in accordance with U.S.
generally accepted accounting principles and follow general practices within the
financial services industry. The most significant accounting policies followed
by the Company are presented in Note 1 to the Consolidated Financial Statements.
These policies, along with the disclosures presented in the other financial
statement notes and in this financial review, provide information on how
significant assets and liabilities are valued in the financial statements and
how those values are determined. Based on the valuation techniques used and the
sensitivity of financial statement amounts to the methods, assumptions, and
estimates underlying those amounts, management has identified the determination
of the allowance for loan losses, valuation of goodwill and other intangible
assets, fair value of investment securities and deferred tax assets to be the
accounting areas that require the most subjective or complex judgments, and as
such could be most subject to revision as new information becomes
available.





Allowance
for Loan Losses





The
allowance for loan losses represents management's estimate of probable credit
losses inherent in the loan portfolio. Determining the amount of the allowance
for loan losses is considered a critical accounting estimate because it requires
significant judgment and the use of estimates related to the amount and timing
of expected future cash flows on impaired loans, estimated fair value of
collateral securing the loans, estimated losses on loans based on historical
loss experience, and consideration of current economic trends and conditions,
all of which may be susceptible to significant change. The loan portfolio also
represents the largest asset type on the consolidated balance sheet. Note 1 to
the Consolidated Financial Statements describes the methodology used to
determine the allowance for loan losses, and a discussion of the factors driving
changes in the amount of the allowance for loan losses is included under "Asset
Quality" below.





Loans
that exhibit probable or observed credit weaknesses are subject to individual
review. Where appropriate, amounts of allowances are allocated to individual
loans based on management's estimate of the borrower's ability to repay the loan
given the availability of collateral, other sources of cash flow and legal
options available to the Company. Included in the review of individual loans are
those that are impaired as provided in SFAS No. 114, "Accounting by Creditors
for Impairment of a Loan." The Company evaluates the collectability of both
principal and interest when assessing the need for a loss accrual. Historical
loss rates are applied to other loans not subject to allowance allocations.
These historical loss rates may be adjusted for significant factors that, in
management's judgment, reflect the impact of any current conditions on loss
recognition. Factors which management considers in the analysis include the
effects of the national and local economies, trends in the nature and volume of
loans (delinquencies, charge-offs and nonaccrual loans), changes in mix, asset
quality trends, risk management and loan administration, changes in internal
lending policies and credit standards, and examination results from bank
regulatory agencies and the Company's internal credit examiners.





The
Company has not substantively changed any aspect to its overall approach in the
determination of the allowance for loan losses. There have been no material
changes in assumptions or estimation techniques as compared to prior periods
that impacted the determination of the current period allowance.





Based on
the procedures discussed above, management is of the opinion that the allowance
of $9.5 million was adequate to address probable incurred credit losses
associated with the loan portfolio at December 31, 2008.






































24
 Index





Goodwill
and Other Intangible Assets





The
Company has a recorded balance of $15.3 million of goodwill and $2.5 million of
other intangible assets at December 31, 2008 in association with its acquisition
of SCSB in 2006.  The Company is required to perform an assessment of
goodwill and other intangible assets to determine potential impairment at least
annually.  Also, management, on an on-going basis, informally reviews
and analyzes certain transactions or events that may indicate potential
impairment of goodwill and other intangible assets throughout the
year.  The analysis and determination of potential impairment and the
identification of relevant factors and events indicating potential impairment
require a high degree of judgment from management.  The Company
performed a formal assessment of goodwill and other intangible assets in the
4th
quarter of the 2008 utilizing the Company’s results of operations through
September 30, 2008 which indicated that goodwill and intangible assets were not
impaired.  Due to the continued decline in the Company’s stock price
during the 4th quarter
of 2008 and the 1st quarter
of 2009 and the results of operations for the 4th quarter
of 2008 the Company performed another formal impairment assessment in the 1st quarter
of 2009.  The second assessment utilized the Company’s results of
operations through December 31, 2008.  For purposes of assessing
impairment, the Company contracted a third party consulting firm to assess the
fair value of the Company, as the market capitalization of the Company was below
the book value of equity for most of 2008.  The impairment analyses
utilized several different approaches and significant assumptions to establish
the fair value of the Company including:  the long and short term
earnings potential of the Company, recent mergers and acquisitions in the
Company’s geographical region, asset valuations, and potential overhead
reduction available to an acquirer.  In evaluating these factors, the
third party consultants relied on management’s representations in providing
relevant estimates and the budgeted 2009 earnings.  The consultants
also considered the thinly traded volume of the Company’s stock in determining
the fair value.  Based on the result of the assessment, the Company
determined that goodwill was not impaired as of December 31, 2008.  No
other events were identified in 2008 which caused us to believe that goodwill or
intangible assets were impaired.





Fair
Value of Investment Securities


The
Company had six trust preferred securities in its investment portfolio as of
December 31, 2008 with a combined book value of $5.7 million and a fair value of
$3.3 million as of the same date.  During 2008, the market for these
types of securities effectively froze as market participants were unwilling to
conduct transactions unless forced to do so.  As a result, the fair
value of these securities deteriorated significantly during
2008.  Given the market conditions, management changed the valuation
source for these types of securities which are provided by a third party to the
Company.  The fair value of these securities is an estimate which is
more difficult to determine due to the current market volatility and
illiquidity.  The new valuation utilizes discounted cash flow models
to value the securities utilizing significant unobservable inputs as defined by
FSP SFAS 157-3.  In management’s estimate, the new valuation method
provided a more relevant and accurate representation of the fair value of these
securities as of December 31, 2008.  Management evaluated the trust
preferred securities for other-than-temporary impairment under FSP EITF 99-20-1
and determined that unrealized losses on these securities should not be recorded
in 2008 earnings.





Deferred
Tax Assets





The
Company has a net deferred tax asset of approximately $1.5 million. The Company
evaluates this asset on a quarterly basis. To the extent the Company believes it
is more likely than not that it will not be utilized, the Company will establish
a valuation allowance to reduce its carrying amount to the amount it expects to
be realized. At December 31, 2008, a valuation allowance of $806,000 has been
established against the outstanding deferred tax asset. Note 12 to the
Consolidated Financial Statements describes the net deferred tax asset. The
deferred tax asset will be utilized as the Company is profitable or as the
Company carries back tax losses to periods in which it paid income taxes. The
estimate of the realizable amount of this asset is a critical accounting
policy.




















25
 Index




Highlights





The
Company’s net income decreased to $821,000 for the year ended December 31, 2008
from $3.5 million for 2007, or 76.6%.  The decrease in net income was
due to a significant increase in the Company’s provision for loan losses of $5.6
million to $6.9 million for 2008 compared to $1.3 million in 2007 as the
Company’s loan portfolio experienced a significant increase in past due loans,
further weakening of collateral securing certain commercial credits, and
continued weakness in the Company’s local market for commercial construction and
development loans.  Net income for 2008 was also negatively impacted
by an increase in non-interest expense of $750,000, or 3.4%.  The
increases in provision for loan losses and non-interest expense were partially
offset by an increase in non-interest income from 2007 of $2.0 million and a
decrease in provision for income taxes of $1.6 million.  The Company’s
book value per share decreased to $19.31 per share at December 31, 2008 from
$19.77 at December 31, 2007.





The
following table summarizes selected financial information regarding the
Company's financial performance:





Table
1 – Summary


For
      the Year Ended December 31,(Dollars in thousands, except per share
      amounts)
                                                                                                
                                                                                                2008
                                                                                                
                                                                                                
                                                                                                2007
                                                                                                
                                                                                                
                                                                                                2006Net
      income
                                                                                                
                                                                                                $
                                                                                                821
                                                                                                
                                                                                                
                                                                                                $
                                                                                                3,503
                                                                                                
                                                                                                
                                                                                                $
                                                                                                4,111Basic
      earnings per share
                                                                                                
                                                                                                
                                                                                                0.25
                                                                                                
                                                                                                
                                                                                                
                                                                                                1.05
                                                                                                
                                                                                                
                                                                                                
                                                                                                1.36Diluted
      earnings per share
                                                                                                
                                                                                                
                                                                                                0.25
                                                                                                
                                                                                                
                                                                                                
                                                                                                1.04
                                                                                                
                                                                                                
                                                                                                
                                                                                                1.35Return
      on average assets
                                                                                                
                                                                                                
                                                                                                0.10
                                                                                                %
                                                                                                
                                                                                                
                                                                                                0.43
                                                                                                %
                                                                                                
                                                                                                
                                                                                                0.55
                                                                                                %Return
      on average equity
                                                                                                
                                                                                                
                                                                                                1.29
                                                                                                
                                                                                                
                                                                                                
                                                                                                5.39
                                                                                                
                                                                                                
                                                                                                
                                                                                                7.73


The
Company’s total assets increased to $877.4 million at December 31, 2008 from
$823.6 million at December 31, 2007 primarily due to an increase in
interest-bearing deposits in other financial institutions of $31.8 million, an
increase in securities available for sale of $22.2 million, and an increase in
cash and due from financial institutions of $5.2 million, offset by a decrease
in net loans of $6.6 million.  Total deposits increased by $29.8
million to $603.2 million at December 31, 2008 with $12.6 million of the
increase attributable to non-interest bearing deposits.  Other
borrowings and FHLB advances increased by $6.2 million and $20.6 million,
respectively, to $79.0 million and $111.9 million as of December 31,
2008.  Total shareholders’ equity decreased by $1.9 million to $62.6
million at December 31, 2008 as the Company declared and paid dividends that
were in excess of net income by $1.5 million in 2008.





Results
of Operations





Net
Interest Income





The
Company’s principal revenue source is net interest income.  Net
interest income is the difference between interest income on interest-earning
assets, such as loans and securities, and the interest expense on the
liabilities used to fund those assets, such as interest-bearing deposits and
borrowings.  Net interest income is impacted by both changes in the
amount and composition of interest-earning assets and interest-bearing
liabilities as well as changes in market interest rates.





In 2008,
net interest income increased by $73,000 to $23.5 million for the year ended
December 31, 2008 from $23.4 million for the equivalent period in 2007 while the
net interest margin on a taxable equivalent basis decreased to 3.09% for 2008
compared to 3.16% for 2007.  The decrease in net interest margin was
the result of the Federal Open Market Committee’s dramatic reduction in the
federal funds rate throughout 2008.  As a result, the Company’s yield
on interest bearing assets decreased by 109 basis points to 5.87% for 2008
compared to 6.96% in 2007, with most of the decrease attributable to a decrease
in the yield on the Company’s loan portfolio.  The cost on interest
bearing liabilities also decreased in 2008 from 4.29% for the year ended
December 31, 2007 to 3.15% for the same period in 2008.  Most of the
decrease in the cost of interest-bearing deposits was due to decreases in the
cost of savings and other deposit accounts of 130 basis points, other borrowings
of 245 basis points, and subordinated debentures of 223 basis
points.





26
 Index




Average
interest earning assets increased to $770.6 million for the year ended December
31, 2008 from $748.1 million for the equivalent period in 2007 as most of the
increase was attributable to increases in interest-bearing deposits in other
financial institutions and loans.  The effect of the increase in
interest-bearing deposits in other financial institutions was to decrease the
yield on average interest earning assets as those deposits primarily consisted
of federal funds sold and other short-term deposits that had an average yield of
1.99% in 2008.  The yield on the Company’s loan portfolio decreased to
6.07% in 2008 from 7.35% in 2007, or 128 basis points.  A large
portion of the Company’s loan portfolio is variable and tied to the prime rate
which decreased throughout 2008 in conjunction with the decrease in the federal
funds rate to a historically low level.  Offsetting the decrease in
loan and interest-bearing deposits in other financial institutions yields, was
an increase in the yield on taxable securities to 5.07% in 2008 from 4.79% in
2007.  Management attributes the increase in yield to maturities of
lower yielding U.S. Government securities that were replaced with higher
yielding mortgage backed securities.





Average
interest bearing liabilities increased to $680.0 million for 2008 from $662.4
million for 2007 due to increases in the average balances of other borrowings
and FHLB advances.  The reduction in the cost of interest bearing
liabilities was affected by the aforementioned decrease in the federal funds
rate as management aggressively lowered rates on the Company’s deposit offerings
throughout 2008 in an effort to substantially match the decrease.  As
a result, the cost of savings and other was reduced to 1.30% in 2008 from 2.60%
in 2007 and time deposits decreased to 3.94% in 2008 from 4.83% in
2007.  As time deposits mature, management plans to price them
accordingly and anticipates a further reduction in the cost over
2009.  The cost of other borrowings decreased to 1.98% for 2008 from
4.43% in 2007, or 245 basis points due primarily to a reduction in rates of the
Company’s repurchase agreements which had carried a weighted average interest
rate of 3.36% at December 31, 2007 compared to a weighted average rate of 0.42%
at December 31, 2008.





Net
interest income increased by $2.3 million, or 10.8%, to $23.4 million for the
twelve months ended December 31, 2007 from $21.1 million for the same period in
2006 due primarily to the acquisition of SCSB on July 1, 2006.  Net
interest margin on a taxable equivalent basis increased by 12 bps to 3.16% for
the year ended 2007 as compared to 3.04% for the same period in
2006.  The increase in net interest margin was driven primarily by an
increase in the yield on interest earning assets, which increased by 22 bps to
6.96% on a fully taxable equivalent basis for the year ended December 31, 2007
from 6.74% for the year ended December 31, 2006.  Most of the increase
in yield on interest earning assets was due to the increase in yield on the
Company’s loan portfolio.  The cost on interest bearing liabilities
increased by 17 bps to 4.29% for the twelve months ended 2007 from 4.12% for the
same period in 2006 due to an increase in the average rate on time
deposits.





Average
interest earning assets increased by 6.5% from $702.2 million for 2006 to $748.1
million for 2007.  The increase in interest earning assets was
primarily due to an increase in average loans of $50.9 million as a result of
the acquisition of SCSB on July 1, 2006 and an increase in the Company’s loan
portfolio during 2007 of $22.5 million.  The yield on the Company’s
loan portfolio increased to 7.35% for the twelve months ended 2007 from 7.19%
for the same period in 2006.  Management attributes the increase in
loan yield to a continued focus on enhancing the net interest margin through
profitable growth in the Company’s loan portfolio and an emphasis on increasing
current and existing customer profitability through evaluation of the entire
relationship, including deposits.  The yield on average earning assets
was also impacted by an increase in the yield on taxable securities of 29 bps
from 4.50% for the year ended 2006 to 4.79% in 2007.  The increase in
the yield on taxable securities was due to maturities and sales of lower
yielding U.S Government and federal agency securities during the
year.  Offsetting the increase in yield on interest earning assets was
a decrease in the fully taxable equivalent yield of tax-exempt securities to
6.69% for the year ended December 31, 2007 from 7.51% for the year ended
December 31, 2006.  Management attributes the decrease to maturities
of higher yielding tax-exempt securities replaced with lower yielding tax-exempt
securities.
































27
 Index




In 2007,
average interest bearing liabilities increased by 5.0% to $662.4 million from
$630.7 million in 2006.  The increase in average interest bearing
liabilities was primarily due to an increase in time deposits which increased to
$273.1 million for the year ended December 31, 2007 from $249.0 million for the
year ended December 31, 2006 with the average rate increasing to 4.83% from
4.36% over the same period.  The increase in the average rate of time
deposits was the result of management’s efforts to maintain and increase the
Company’s deposit base in a competitive local market.  The Company was
able to decrease its cost on other borrowings to 4.43% for the twelve months
ended in 2007 from 4.76% for the same period in 2006 by obtaining a $9.8 million
structured repurchase agreement entered into in the fourth quarter of 2007 that
had a yield of 2.79% at December 31, 2007.  Also contributing to the
reduction in the average rate of other borrowings was a decrease in the average
rate paid on the Company’s repurchase agreements from 4.84% for 2006 to 3.36%
for 2007 and a decrease in the federal funds rate of 100 bps during
2007.  The increase in the net interest margin on a fully taxable
equivalent basis in 2007 was further enhanced by an increase in average
non-interest bearing deposits of $18.7 million, or 30.1%, to $80.8 million for
2007 from $62.1 million for 2006 due to the acquisition of SCSB on July 1, 2006
and a focused effort to increase non-interest bearing deposits through employee
incentives, increased deposit product offerings including remote deposit capture
and lockbox, and cross-selling of current and prospective loan
customers.








































































































28
 Index


Table 2
provides detailed information as to average balances, interest income/expense,
and rates by major balance sheet category for 2006 through
2008.


Table
2 - Average Balance Sheets and Rates for Years Ended 2008, 2007 and
2006





For
analytical purposes, net interest margin and net interest spread are adjusted to
a taxable equivalent adjustment basis to recognize the income tax savings on
tax-exempt assets, such as state and municipal securities.  A tax rate
of 34% was used in adjusting interest on tax-exempt assets to a fully taxable
equivalent (“FTE”) basis.





2008
                    
                    
                    2007
                    
                    
                    2006Average
                    
                    
                    
                    
                    
                    Average
                    
                    
                    Average
                    
                    
                    
                    
                    
                    Average
                    
                    
                    Average
                    
                    
                    
                    
                    
                    Average(Dollars
      in thousands)
                    
                    Balance
                    
                    
                    Interest
                    
                    
                    Rate
                    
                    
                    Balance
                    
                    
                    Interest
                    
                    
                    Rate
                    
                    
                    Balance
                    
                    
                    Interest
                    
                    
                    RateASSETSEarning
      assets:Interest-bearing
      deposits in other
      financial institutions
                    
                    $
                    12,122
                    
                    
                    $
                    241
                    
                    
                    
                    1.99
                    %
                    
                    $
                    4,279
                    
                    
                    $
                    144
                    
                    
                    
                    3.37
                    %
                    
                    $
                    4,365
                    
                    
                    $
                    132
                    
                    
                    
                    3.02
                    %Taxable securities
                    
                    
                    94,667
                    
                    
                    
                    4,798
                    
                    
                    
                    5.07
                    
                    
                    
                    98,342
                    
                    
                    
                    4,711
                    
                    
                    
                    4.79
                    
                    
                    
                    105,287
                    
                    
                    
                    4,738
                    
                    
                    
                    4.50Tax-exempt securities
                    
                    
                    16,350
                    
                    
                    
                    1,056
                    
                    
                    
                    6.46
                    
                    
                    
                    11,546
                    
                    
                    
                    773
                    
                    
                    
                    6.69
                    
                    
                    
                    9,419
                    
                    
                    
                    708
                    
                    
                    
                    7.51Total loans and fees (1)(2)
                    
                    
                    639,275
                    
                    
                    
                    38,833
                    
                    
                    
                    6.07
                    
                    
                    
                    625,972
                    
                    
                    
                    46,030
                    
                    
                    
                    7.35
                    
                    
                    
                    575,100
                    
                    
                    
                    41,360
                    
                    
                    
                    7.19FHLB and Federal Reserve stock
                    
                    
                    8,141
                    
                    
                    
                    338
                    
                    
                    
                    4.15
                    
                    
                    
                    7,928
                    
                    
                    
                    381
                    
                    
                    
                    4.81
                    
                    
                    
                    8,028
                    
                    
                    
                    397
                    
                    
                    
                    4.95Total
      earning assets
                    
                    
                    770,555
                    
                    
                    
                    45,266
                    
                    
                    
                    5.87
                    
                    
                    
                    748,067
                    
                    
                    
                    52,039
                    
                    
                    
                    6.96
                    
                    
                    
                    702,199
                    
                    
                    
                    47,335
                    
                    
                    
                    6.74Non-interest
      earning assets:Less:
      Allowance for loan losses
                    
                    
                    (6,763
                    )
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (5,684
                    )
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (5,823
                    )Non-earning assets:Cash and due from banks
                    
                    
                    24,924
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    17,047
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    15,759Bank premises and equipment, net
                    
                    
                    15,160
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    15,320
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    13,827Other assets
                    
                    
                    40,266
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    40,440
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    22,505Total
      assets
                    
                    $
                    844,142
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    815,190
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    748,467LIABILITIES
      AND SHAREHOLDERS’ EQUITYInterest
      bearing liabilities:Savings and other
                    
                    $
                    212,475
                    
                    
                    $
                    2,771
                    
                    
                    
                    1.30
                    %
                    
                    $
                    214,683
                    
                    
                    $
                    5,582
                    
                    
                    
                    2.60
                    %
                    
                    $
                    218,981
                    
                    
                    $
                    6,071
                    
                    
                    
                    2.77
                    %Time deposits
                    
                    
                    272,847
                    
                    
                    
                    10,758
                    
                    
                    
                    3.94
                    
                    
                    
                    273,078
                    
                    
                    
                    13,201
                    
                    
                    
                    4.83
                    
                    
                    
                    249,036
                    
                    
                    
                    10,862
                    
                    
                    
                    4.36Other borrowings
                    
                    
                    70,691
                    
                    
                    
                    1,403
                    
                    
                    
                    1.98
                    
                    
                    
                    63,713
                    
                    
                    
                    2,824
                    
                    
                    
                    4.43
                    
                    
                    
                    64,153
                    
                    
                    
                    3,054
                    
                    
                    
                    4.76FHLB advances
                    
                    
                    106,969
                    
                    
                    
                    5,605
                    
                    
                    
                    5.24
                    
                    
                    
                    93,889
                    
                    
                    
                    5,492
                    
                    
                    
                    5.85
                    
                    
                    
                    86,024
                    
                    
                    
                    5,066
                    
                    
                    
                    5.89Subordinated debenture
                    
                    
                    17,000
                    
                    
                    
                    916
                    
                    
                    
                    5.39
                    
                    
                    
                    17,000
                    
                    
                    
                    1,296
                    
                    
                    
                    7.62
                    
                    
                    
                    12,479
                    
                    
                    
                    942
                    
                    
                    
                    7.55Total
      interest bearing liabilities
                    
                    
                    679,982
                    
                    
                    
                    21,453
                    
                    
                    
                    3.15
                    
                    
                    
                    662,363
                    
                    
                    
                    28,395
                    
                    
                    
                    4.29
                    
                    
                    
                    630,673
                    
                    
                    
                    25,995
                    
                    
                    
                    4.12Non-interest
      bearing liabilities:Non-interest bearing deposits
                    
                    
                    97,726
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    80,782
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    62,079Other liabilities
                    
                    
                    2,633
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    7,048
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    2,507Shareholders’ equity
                    
                    
                    63,801
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    64,997
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    53,208Total
      liabilities and shareholders’ equity
                    
                    $
                    844,142
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    815,190
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    748,467Net
      interest income (taxable equivalent basis)
                    
                    
                    
                    
                    
                    
                    23,813
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    23,644
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    21,340Less:
      taxable equivalent adjustment
                    
                    
                    
                    
                    
                    
                    (359
                    )
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (263
                    )
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (241
                    )Net
      interest income
                    
                    
                    
                    
                    
                    
                    23,454
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    23,381
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    21,099Net
      interest spread
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    2.72
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    2.67
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    2.62
                    %Net
      interest margin
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.09
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.16
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.04
                    %





(1)   The
amount of direct loan origination cost included in interest on loans was $412
for the year ended December 31, 2008. The amount of fee income included in
interest on loans was $566 and $697 for the years ended December 31, 2007 and
2006, respectively.


(2)  Includes
loans held for sale and non-accruing loans in the average loan amounts
outstanding.


29
 Index


Table 3
illustrates the extent to which changes in interest rates and changes in the
volume of interest-earning assets and interest-bearing liabilities affected the
Company's interest income and interest expense during the periods
indicated.  Information is provided in each category with respect to
(i) changes attributable to changes in volume (changes in volume multiplied by
prior rate), (ii) changes attributable to changes in rate (changes in rate
multiplied by prior volume), and (iii) the net change.  The changes
attributable to the combined impact of volume and rate have been allocated
proportionately to the changes due to volume and the changes due to
rate.








Table
3 - Volume/Rate Variance Analysis





Year
      Ended December 31,2008
                        compared
      to
                        Year Ended December 31,
2007
                      
                      
                      Year
      Ended December 31,2007
                        compared
      to
                        Year Ended December 31,
2006INCREASE/(DECREASE)
                        Due to
                      
                      
                      INCREASE/(DECREASE)
                        Due toTotal
      Net
                        Change
                      
                      
                      Volume
                      
                      
                      Rate
                      
                      
                      Total
      Net
                        Change
                      
                      
                      Volume
                      
                      
                      RateInterest
      income:Interest-bearing
      deposits with banks
                      
                      $
                      97
                      
                      
                      
                      176
                      
                      
                      
                      (79
                      )
                      
                      $
                      12
                      
                      
                      
                      (3
                      )
                      
                      
                      15Taxable
      securities
                      
                      
                      87
                      
                      
                      
                      (180
                      )
                      
                      
                      267
                      
                      
                      
                      (27
                      )
                      
                      
                      (323
                      )
                      
                      
                      296Tax-exempt
      securities
                      
                      
                      187
                      
                      
                      
                      205
                      
                      
                      
                      (18
                      )
                      
                      
                      43
                      
                      
                      
                      98
                      
                      
                      
                      (55
                      )Total
      loans and fees
                      
                      
                      (7,197
                      )
                      
                      
                      960
                      
                      
                      
                      (8,157
                      )
                      
                      
                      4,670
                      
                      
                      
                      3,724
                      
                      
                      
                      946FHLB
      and Federal Reserve stock
                      
                      
                      (43
                      )
                      
                      
                      10
                      
                      
                      
                      (53
                      )
                      
                      
                      (16
                      )
                      
                      
                      (5
                      )
                      
                      
                      (11
                      )Total
      increase (decrease) in interest income
                      
                      
                      (6,869
                      )
                      
                      
                      1,171
                      
                      
                      
                      (8,040
                      )
                      
                      
                      4,682
                      
                      
                      
                      3,491
                      
                      
                      
                      1,191Interest
      expense:Savings
      and other
                      
                      
                      (2,811
                      )
                      
                      
                      (57
                      )
                      
                      
                      (2,754
                      )
                      
                      
                      (489
                      )
                      
                      
                      (117
                      )
                      
                      
                      (372
                      )Time
      deposits
                      
                      
                      (2,443
                      )
                      
                      
                      (11
                      )
                      
                      
                      (2,432
                      )
                      
                      
                      2,339
                      
                      
                      
                      1,102
                      
                      
                      
                      1,237Other
      borrowings
                      
                      
                      (1,421
                      )
                      
                      
                      281
                      
                      
                      
                      (1,702
                      )
                      
                      
                      (230
                      )
                      
                      
                      (21
                      )
                      
                      
                      (209
                      )FHLB
      advances
                      
                      
                      113
                      
                      
                      
                      719
                      
                      
                      
                      (606
                      )
                      
                      
                      426
                      
                      
                      
                      460
                      
                      
                      
                      (34
                      )Subordinated
      debenture
                      
                      
                      (380
                      )
                      
                      
                      -
                      
                      
                      
                      (380
                      )
                      
                      
                      354
                      
                      
                      
                      345
                      
                      
                      
                      9Total
      increase (decrease) in interest expense
                      
                      
                      (6,942
                      )
                      
                      
                      932
                      
                      
                      
                      (7,874
                      )
                      
                      
                      2,400
                      
                      
                      
                      1,769
                      
                      
                      
                      631Increase
      (decrease) in net interest income
                      
                      $
                      73
                      
                      
                      $
                      239
                      
                      
                      $
                      (166
                      )
                      
                      $
                      2,282
                      
                      
                      $
                      1,722
                      
                      
                      $
                      560








Non-interest
Income




Non-interest
income was $6.1 million for 2008, $4.1 million for 2007, and $3.7 million for
2006.  For the year ended December 31, 2008, non-interest income
increased 47.5% as compared to 2007 due to an increase in service charges on
deposit accounts of $169,000, a net gain on sales of available for sale
securities of $405,000, and a change in the fair value and cash settlement of
interest rate swaps that had a positive impact of $1.4 million, offset by
decreases in mortgage banking income of $69,000 and other income of
$158,000.  In 2007, non-interest income increased 10.6% compared to
2006 primarily due to the acquisition of SCSB which provided twelve months of
non-interest income in 2007 as compared to six months in 2006. Also factoring
into the increase in non-interest income were increases in service charges on
deposit accounts of $233,000, commission income of $65,000, interchange income
of $171,000, other income of $152,000, and earnings on company owned life
insurance of $105,000, offset by an increase in the change in fair value and
cash settlement of interest rate swaps of $187,000 and a decrease in mortgage
banking income of $86,000.





30
 Index




Table 4
provides a breakdown of the Company’s non-interest income during the past three
years.








Table
4 - Analysis of Non-interest Income





Year Ended December 31,
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  Percent Increase/(Decrease)(Dollars
      in thousands)
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  2008
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  2007
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  2006
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  2008/2007
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  2007/2006Service
      charges on deposit accounts
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  $
                                                                                                                                                                                                                                                                                                                                  3,356
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  $
                                                                                                                                                                                                                                                                                                                                  3,187
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  $
                                                                                                                                                                                                                                                                                                                                  2,954
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  5.3
                                                                                                                                                                                                                                                                                                                                  %
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  7.9
                                                                                                                                                                                                                                                                                                                                  %Commission
      income
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  194
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  172
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  107
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  12.8
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  60.7Mortgage
      banking income
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  167
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  236
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  322
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  (29.2
                                                                                                                                                                                                                                                                                                                                  )
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  (26.7
                                                                                                                                                                                                                                                                                                                                  )Earnings
      on company owned life insurance
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  734
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  678
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  573
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  8.3
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  18.3Change
      in fair value and cash settlement of interest rate swaps
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  180
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  (1,248
                                                                                                                                                                                                                                                                                                                                  )
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  (1,061
                                                                                                                                                                                                                                                                                                                                  )
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  NM
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  17.6Interchange
      income
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  811
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  704
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  533
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  15.2
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  32.1Other
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  281
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  439
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  287
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  (36.0
                                                                                                                                                                                                                                                                                                                                  )
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  53.0Subtotal
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  5,723
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  4,168
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  3,715
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  37.3
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  12.2Gain
      on disposition of equity stock
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  -
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  -
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  18
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  -
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  (100.0
                                                                                                                                                                                                                                                                                                                                  )Gain
      (loss) on sale of available for sale securities
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  364
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  (41
                                                                                                                                                                                                                                                                                                                                  )
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  -
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  NM
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  NMTotal
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  $
                                                                                                                                                                                                                                                                                                                                  6,087
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  $
                                                                                                                                                                                                                                                                                                                                  4,127
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  $
                                                                                                                                                                                                                                                                                                                                  3,733
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  47.5
                                                                                                                                                                                                                                                                                                                                  %
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                  10.6
                                                                                                                                                                                                                                                                                                                                  %





Service
charges on deposit accounts increased by $169,000, or 5.3%, to $3.4 million for
the year ended December 31, 2008 primarily due to fee income related to a new
retail deposit product implemented during 2007 and secondarily to an increase in
non-sufficient funds fees.  In 2007, service charges on deposit
accounts increased by 7.9% from 2006 to $3.2 million due primarily to
acquisition of SCSB in 2006 which provided deposit service charge income of
$700,000 in 2007 as compared to $326,000 in 2006.  Excluding the
impact of the SCSB acquisition, income from service charges on deposit accounts
was relatively flat as the Company experienced moderate deposit growth without
significant changes in its service charge fee structure.





Commission
income from investment products offered to customers through its alliance with
Smith Barney increased 60.7% in 2007 as compared to 2006 due to changes in Smith
Barney’s fee commission structure and an increase in assets under management
which led to an increase in fees realized.





In 2008,
the Company sold certain available for sale securities for a net gain of
$364,000 as compared to a net loss of $41,000 in 2007.  Management was
able to sell certain securities within its portfolio at a gain and reinvest the
proceeds into securities with substantially the same yield with slightly longer
maturities.




Earnings on
company owned life insurance increased to $734,000 for the twelve months in 2008
as compared to $678,000 in 2007.  In the first quarter of 2008, the
Company exchanged a significant portion of its outstanding contracts for higher
yielding contracts resulting in increased income. In 2007, earnings on company
owned life insurance increased by 18.3% from 2006 to $678,000 in 2007 as the
Company purchased $2.1 million of life insurance in the second half of 2006 for
certain key executives of SCSB.  Earnings on company owned life
insurance of SCSB was $87,000 for the year ended December 31, 2007 as compared
to $21,000 for the same period in 2006.





























31
 Index




The
change in fair value and cash settlement of interest rate swaps was $180,000 for
the twelve months ended December 31, 2008 as compared to $(1.2) million in
2007.   In the fourth quarter of 2007, management determined that
the Company’s documentation of the effectiveness of the hedge relationship was
insufficient to support hedge accounting.  Accordingly, the Company
was disqualified from hedge accounting treatment and began accounting for the
interest rate swap as a stand-alone derivative; the unrealized loss on the
interest rate swap at December 31, 2007 of $234,000 was reclassified from
accumulated other comprehensive loss to non-interest income.  In
accordance with the Company’s accounting policy, the change in the fair value of
the swap was reported prospectively in non-interest income along with interest
rate settlements associated with the swap agreement.  For purposes of
improving comparability of the Company’s financial statements, interest rate
settlements for the Company’s interest rate swaps for the years ended December
31, 2007 and 2006 were reclassified to non-interest income from interest income
as well.  In 2008,
the Company’s last remaining interest rate swap contract expired; the Company
reported an unrealized gain of $234,000 on the interest rate swap in 2008,
netted against interest rate settlements of $54,000 compared to an unrealized
loss of $234,000 and interest rate settlements of $1.0 million in
2007.




Mortgage
banking income decreased to $167,000 in 2008 from $236,000 in
2007.  The decline is attributable to an impairment charge of $69,000
recorded in 2008 related to the Company’s mortgage servicing
rights.  In 2008, the Company determined the fair value of its
mortgage servicing rights had declined due to a significant increase in the
assumed prepayments for the loan portfolio serviced.  Excluding the
impairment charge, mortgage banking income was consistent with
2007.  Mortgage banking income declined by 26.7% for the year ended
December 31, 2007 as compared to 2006.  The decrease in mortgage
banking income in 2007 reflects decreased origination activity in the two
periods.





Other
income was $281,000 for the year ended December 31, 2008 as compared to $439,000
for the same period in 2007, a decrease of $158,000, or 36.0%.  The
decline was driven by a decrease in income from merchant card services during
2008 of approximately $100,000 due to a change in a third party vendor during
the year that temporarily disrupted the Company’s income and also due to a
one-time gain recorded in 2007 related to the settlement of the SCSB pension
plan.  In 2007, other income increased by $152,000, or 53.0% from
$287,000 for the twelve months ended December 31, 2006 to $439,000 for 2007 due
primarily to the acquisition of SCSB, which provided $139,000 of other income in
2007 as compared to $27,000 in 2006 and the settlement of the SCSB pension plan
that had been curtailed in accordance with the merger agreement, resulting in a
gain of $49,000.





Non-interest
Expense





Non-interest
expense increased to $22.6 million for the year ended December 31, 2008 from
$21.8 million as of December 31, 2007, or 3.4% due to increases in salaries and
employee benefits of $659,000, occupancy expense of $409,000, and marketing and
advertising of $155,000, offset by decreases in data processing expenses of
$252,000, legal and professional services of $230,000, and other expenses of
$80,000.  Total non-interest expense increased 14.1% to $21.8 million
in 2007 when compared with 2006 primarily due to the acquisition of SCSB in 2006
which incurred six months of expense in 2006 as compared to twelve months in
2007.  Other factors for the increase in non-interest expense include
occupancy expenses, equipment, legal and professional, and other
expenses.





Table 5
provides a breakdown of the Company’s non-interest expense for the past three
years.






































32
 Index





Table
5 - Analysis of Non-interest Expense


Year Ended in
      December 31,
                  
                  
                  Percent Increase/(Decrease)(Dollars
      in thousands)
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  
                  2008/2007
                  
                  
                  
                  2007/2006Salaries
      and employee benefits
                  
                  $
                  12,125
                  
                  
                  $
                  11,466
                  
                  
                  $
                  10,345
                  
                  
                  
                  5.7
                  %
                  
                  
                  10.8
                  %Occupancy
                  
                  
                  2,169
                  
                  
                  
                  1,760
                  
                  
                  
                  1,479
                  
                  
                  
                  23.2
                  
                  
                  
                  19.0Equipment
                  
                  
                  1,535
                  
                  
                  
                  1,446
                  
                  
                  
                  1,188
                  
                  
                  
                  6.2
                  
                  
                  
                  21.7Data
      processing
                  
                  
                  1,931
                  
                  
                  
                  2,183
                  
                  
                  
                  2,162
                  
                  
                  
                  (11.5
                  )
                  
                  
                  1.0Marketing
      and advertising
                  
                  
                  738
                  
                  
                  
                  583
                  
                  
                  
                  527
                  
                  
                  
                  26.6
                  
                  
                  
                  10.6Legal
      and professional
                  
                  
                  1,153
                  
                  
                  
                  1,383
                  
                  
                  
                  1,097
                  
                  
                  
                  (16.6
                  )
                  
                  
                  26.1Other
                  
                  
                  2,903
                  
                  
                  
                  2,983
                  
                  
                  
                  2,318
                  
                  
                  
                  (2.7
                  )
                  
                  
                  28.7Total
                  
                  $
                  22,554
                  
                  
                  $
                  21,804
                  
                  
                  $
                  19,116
                  
                  
                  
                  3.4
                  %
                  
                  
                  14.1
                  %











Salaries
and benefits, the largest component of non-interest expense, increased to $12.1
million for the twelve months ended December 31, 2008 compared to $11.5 million
for the same period in 2007 due primarily to increases in benefits provided to
employees.  In 2008, health insurance premiums for employees increased
by approximately $160,000 while other benefits, including the Company match for
the 401(k), increased by approximately $246,000.  The Company’s
full-time equivalent employees increased to 238 at December 31, 2008 from 232 at
December 31, 2007 due to a new branch location in Louisville, Kentucky which
also increased the Company’s salary expense in addition to normal, recurring
raises.  The increase in salaries and benefits was partially offset by
an increase in deferred loan origination costs of $355,000.  In 2007,
salaries and benefits increased 10.8% to $11.5 million in 2007 compared to $10.3
million in 2006 due primarily to the acquisition of SCSB.  The
Company’s full-time equivalent employees increased to 232 at December 31, 2007
compared to 224 at December 31, 2006 due to the opening of new YCB branch in
Jeffersonville, Indiana and the hiring of additional commercial loan
officers.





Occupancy
expense increased to $2.2 million for 2008 compared to $1.8 million in 2007 as
the Company opened a new YCB branch location in the second quarter of 2008 which
resulted in approximately $107,000 in additional 2008 lease
expense.  In addition to the new branch location, the Company incurred
increased expenses in maintenance expense and property
taxes.  Occupancy expenses increased 19.0% to $1.8 million for 2007
compared with $1.5 million for 2006.  The increase in occupancy
expense is due primarily to the opening of a new YCB branch in Jeffersonville,
Indiana in the second quarter of 2007 which contributed to an increase in rent
expense to $512,000 for 2007 compared to $409,000 for 2006 along with slight
increases in renewed lease agreements. The remaining increase is related to
increased utilities, taxes, repairs and maintenance, and depreciation associated
with new branches opened in 2006 and 2007 and the acquisition of SCSB, which
accounted for a full year of occupancy expenses versus six months in
2006.





Data
processing expenses decreased by $252,000 from the twelve months ended December
31, 2007 to $1.9 million in 2008.   The decrease was due to
repricing of service fees that was negotiated with YCB’s third party core data
processor in connection with executing a new contract and upgrading from YCB’s
current system.  Data processing expenses increased slightly by
$21,000 to $2.2 million for the year ended December 31, 2007 as compared to the
prior year.  An increase in data processing expense due to the
acquisition of SCSB in 2006, which resulted in six months of expenses in 2006
compared to twelve 2007, was almost fully offset by decreases in software
maintenance expenditures and a decrease in processing charges from YCB’s third
party core data processor.





Equipment
expense was $1.5 million for the year ended December 31, 2008, an increase of
6.2% from 2007 due to additional equipment additions related to the new YCB
branch.  Equipment expenses increased 21.7% to $1.4 million at
December 31, 2007 compared to $1.2 million at December 31, 2006 primarily due to
the acquisition of SCSB. Excluding the effect of the SCSB acquisition, equipment
expenses increased 7.3% in 2007 compared to 2006. The increase is primarily due
to additional depreciation expense on software from replacements and renewals of
software licenses and in furniture and fixtures expenses related to the new YCB
branch in Jeffersonville, Indiana.










33
 Index




Marketing
and advertising expense increased to $738,000 for the year ended December 31,
2008 from $583,000 for the equivalent period in 2007.  The increase
was the due to marketing efforts in the second quarter of 2008 related to the
new YCB branch, a new branding campaign and related materials, and other
promotional expenditures.




Legal and
professional fees decreased by $230,000, or 16.6%, to $1.2 million for the year
ended December 31, 2008.  The
decrease was attributable to certain consulting projects performed in 2007 that
were not repeated in 2008 including studies related to compensation and
assistance with selecting and negotiating the Company’s contract with its third
party core data processor. Legal and professional fees increased
26.1% to $1.4 million in 2007 compared to $1.1 million in 2006. The increase was
due to additional consulting expenses incurred for implementation of Section 404
of the Sarbanes-Oxley Act and the evaluation of prospective data service
providers as well as legal fees related to loan collection efforts, human
resource consultations, assistance with the audits of our tax returns, and the
review of various SEC filings.




Other
expenses decreased to $2.9 million for the year ended December 31, 2008 from
$3.0 million for the equivalent period in 2007.  The decrease is
attributable to a decline in deposit account charge-offs from external fraud due
to the implementation of software and procedures during 2008 that has allowed
the Company to more effectively monitor and identify unusual activity in
customer accounts.  Also, in 2007, the Company accrued $200,000 for
the probable settlement of ongoing litigation.  In 2008, the Company
settled the litigation with the third party and paid an amount materially
consistent with the amount accrued.  Accordingly, the Company did not
recognize additional expense in 2008 associated with any ongoing
litigation.  Offsetting the decreases described above, was an increase
in the Company’s FDIC assessment to insure the Company’s depositors against
loss.  During 2008, YCB’s assessment increased dramatically due to the
expiration of a credits granted and an increase in its assessment
base.  As a result, the Company’s FDIC assessment increased by
approximately $414,000 (see Part I, Item 1A “Risk Factors” for discussion of
subsequent changes to the Company’s FDIC assessment).  Other expenses
increased 28.7% to $3.0 million in 2007 compared to 2006 primarily due to the
acquisition of SCSB, which incurred approximately $853,000 and $344,000 of other
expenses in 2007 and 2006, respectively.  The Company recognized
amortization expense of a core deposit and customer intangible assets acquired
as part of the transaction of $438,000 and $176,000 for 2007 and 2006,
respectively (see Note 5 to the Company’s consolidated financial
statements).  Another factor contributing to the increase in other
expenses was the accrual of $200,000 for the probable settlement of ongoing
litigation as noted above (see Part I, Item 3 for further
discussion).





Financial
Condition





Loan
Portfolio





The
Company’s loan portfolio decreased by 0.5% to $632.6 million as of December 31,
2008 from $636.0 million as of the same date in 2007.  The decrease in
the loan portfolio was primarily concentrated in residential real estate,
construction, and consumer loans, which was partially offset by increases in the
commercial and commercial real estate portfolio.  Given the current
economic and interest rate environment, management has attempted to focus on
originating loans that will improve profitability and meet the Company’s
underwriting criteria.  The Company’s loan portfolio mix remained
relatively consistent with the percentage of commercial and commercial real
estate loans to total loans increasing to 47.8% as of December 31, 2008 from
44.0% at December 31, 2007.





Residential
real estate loans decreased by $9.6 million to $177.2 million at December 31,
2008 from $186.8 million as of December 31, 2007.  The Company
currently sells a majority of the residential real estate loans it originates
into the secondary market resulting in payments not being fully offset by new
residential real estate originations.  Also impacting residential real
estate loans during the year, was a decline in demand as sales of residential
properties slowed amid declining home values and the weaker local economic
environment.  Residential real estate loans represented 28.0% of
outstanding loans as of December 31, 2008, down from 29.4% at December 31,
2007.

















34
 Index




Construction
real estate loans declined by $13.4 million in 2008 to $73.9 million as of the
year ended December 31, 2008 from $87.4 million at December 31,
2007.  Beginning in late 2007 and continuing into 2008, the Company
experienced a high rate of delinquencies in its construction loan portfolio in
addition to a noted deterioration in the collateral values of the developments
securing the loans.  The Company has noted that real estate developers
in its market have experienced greater strain in the current economic climate
which has reduced their ability to withstand a slowdown in sales of their
developed units.  Accordingly, the Company has significantly reduced
its loan originations to real estate developers during 2008 resulting in a
substantial decline in the outstanding balance as those loans are paid (see
further discussion below in “Allowance and Provision for Loan Losses” regarding
the Company’s construction portfolio).





Commercial
and commercial real estate loans grew by $7.0 million and $15.2 million in 2008
to $95.4 million and $207.0 million, respectively, from $88.4 million and $191.8
million as of December 31, 2007.  The growth in Commercial loans
during 2008 is attributable to management’s focus on diversifying the Company’s
commercial loan portfolio, particularly from construction real estate
loans.  Commercial real estate loans have also increased in 2008 as
the Company continued to focus on growing the portfolio at a measured pace,
focusing on loan quality and profitability.





At the
end of 2008, the Company was servicing $14.4 million in mortgage loans for other
investors compared to $17.3 million in 2007.  Loans serviced for
others consist of loans the Company has sold to the Federal National Mortgage
Association and the Federal Home Loan Mortgage Corporation with servicing rights
retained by the Company.





The
Company’s lending activities remain primarily concentrated within its existing
markets, and are principally comprised of loans secured by single-family
residential housing developments, owner occupied manufacturing and retail
facilities, general business assets, and single-family residential real
estate.  The Company emphasizes the acquisition of deposit
relationships from new and existing commercial business and real estate loan
clients.





Table 6
provides a breakdown of the Company’s loans by type during the past five
years.








Table
6 - Loans by Type


As
      of December 31,(Dollars
      in thousands)
                                                                                                                                                                                                            
                                                                                                                                                                                                            2008
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            2007
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            2006
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            2005
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            2004Real
      estate:Residential
                                                                                                                                                                                                            
                                                                                                                                                                                                            $
                                                                                                                                                                                                            177,230
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            $
                                                                                                                                                                                                            186,831
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            $
                                                                                                                                                                                                            187,080
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            $
                                                                                                                                                                                                            111,969
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            $
                                                                                                                                                                                                            100,553Commercial
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            206,973
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            191,774
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            179,405
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            186,644
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            186,175Construction
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            73,936
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            87,364
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            83,944
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            61,031
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            38,638Commercial
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            95,365
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            88,353
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            80,132
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            92,640
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            73,374Home
      equity
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            60,539
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            60,380
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            62,720
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            58,060
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            49,677Consumer
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            17,296
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            20,024
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            19,549
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            7,295
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            6,095Loans
      secured by deposit accounts
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            1,242
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            1,322
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            756
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            729
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            687Total
      loans
                                                                                                                                                                                                            
                                                                                                                                                                                                            $
                                                                                                                                                                                                            632,581
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            $
                                                                                                                                                                                                            636,048
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            $
                                                                                                                                                                                                            613,586
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            $
                                                                                                                                                                                                            518,368
                                                                                                                                                                                                            
                                                                                                                                                                                                            
                                                                                                                                                                                                            $
                                                                                                                                                                                                            455,199





35
 Index




Table 7
illustrates the Company’s fixed rate maturities and repricing frequency for the
loan portfolio.





Table
7 - Selected Loan Distribution


As
      of December 31, 2008
                  (Dollars
      in thousands)
                
                Total
                
                
                One
                  Year
      or
                  Less
                
                
                Over
      One
                  Through
      Five
                  Years
                
                
                Over
                  Five
                  YearsFixed
      rate maturities:Real
      estate:Residential
                
                $
                141,594
                
                
                $
                6,913
                
                
                $
                33,281
                
                
                $
                101,400Commercial
                
                
                95,283
                
                
                
                9,871
                
                
                
                61,745
                
                
                
                23,667Construction
                
                
                9,467
                
                
                
                1,616
                
                
                
                3,748
                
                
                
                4,103Commercial
                
                
                40,286
                
                
                
                7,943
                
                
                
                25,929
                
                
                
                6,414Home
      equity
                
                
                15,165
                
                
                
                271
                
                
                
                6,190
                
                
                
                8,704Consumer
                
                
                17,043
                
                
                
                3,448
                
                
                
                12,579
                
                
                
                1,016Loans
      secured by deposit accounts
                
                
                1,242
                
                
                
                420
                
                
                
                804
                
                
                
                18Total
      fixed rate maturities
                
                $
                320,080
                
                
                $
                30,482
                
                
                $
                144,276
                
                
                $
                145,322Variable
      rate maturities:Real
      estate:Residential
                
                $
                35,636
                
                
                $
                13,907
                
                
                $
                1,185
                
                
                $
                20,544Commercial
                
                
                111,690
                
                
                
                19,701
                
                
                
                5,224
                
                
                
                86,765Construction
                
                
                64,469
                
                
                
                53,853
                
                
                
                7,901
                
                
                
                2,715Commercial
                
                
                55,079
                
                
                
                50,113
                
                
                
                3,382
                
                
                
                1,584Home
      equity
                
                
                45,374
                
                
                
                5,535
                
                
                
                11,253
                
                
                
                28,586Consumer
                
                
                253
                
                
                
                222
                
                
                
                31
                
                
                
                -Total
      variable rate maturities
                
                $
                312,501
                
                
                $
                143,331
                
                
                $
                28,976
                
                
                $
                140,194








Allowance
and Provision for Loan Losses





Federal
regulations require insured institutions to classify their assets on a regular
basis.  The regulations provide for three categories of classified
loans:  substandard, doubtful and loss.  The regulations
also contain a special mention and a specific allowance
category.  Special mention is defined as loans that do not currently
expose an insured institution to a sufficient degree of risk to warrant
classification but do possess credit deficiencies or potential weaknesses
deserving management’s close attention.  Assets classified as
substandard or doubtful require the institution to establish general allowances
for loan losses.  If an asset or portion thereof is classified as
loss, the insured institution must either establish specified allowances for
loan losses in the amount of 100% of the portion of the asset classified loss,
or charge off such amount.





The
Company maintains the allowance for loan losses at a level that is sufficient to
absorb probable credit losses incurred in its loan portfolio.  The
allowance is determined based on the application of loss estimates to graded
loans by categories.  Management determines the level of the allowance
for loan losses based on its evaluation of the collectability of the loan
portfolio, including the composition of the portfolio, historical loan loss
experience, specific impaired loans, and general economic
conditions.  Allowances for impaired loans are generally determined
based on collateral values or the present value of estimated future cash
flows.  The allowance for loan losses is increased by a provision for
loan losses, which is charged to expense, and reduced by charge-offs of specific
loans, net of recoveries.  Changes in the allowance relating to
impaired loans are charged or credited directly to the provision for loan
losses.  As of December 31, 2008, the Company’s allowance for loan
losses totaled $9.5 million, an increase of $3.2 million from December 31, 2007
which increased the allowance for loan losses to total loans ratio to 1.50% from
0.99% for the same periods, respectively.  The increase in the
allowance was attributable to a significant increase in the provision for loan
losses, offset by an increase in charge-offs.  The Company’s net
charge-offs totaled $3.7 million in 2008, up from $634,000 for the 2007 fiscal
year as all loan categories experienced a substantial increase from the prior
year.  Beginning in late 2007 and continuing into 2008 the Company’s
loan portfolio has experience an increase in past due loans, impaired loans, and
classified loans which has led to an increase in charge-offs for those credits
management has determined to be uncollectible.  Management has
allocated amounts for probable incurred losses in the Company’s loan portfolio
based on the best estimate available as of December 31, 2008.





36
 Index




Provisions
for loan losses are charged against earnings to bring the total allowance for
loan losses to a level considered adequate by management based on historical
experience, the volume and type of lending conducted by the Company, the status
of past due principal and interest payments, general economic conditions, and
inherent credit risk related to the collectability of the Company’s loan
portfolio.  The provision for loan losses increased to $6.9
millionfor the
twelve months ended December 31, 2008 from $1.3 million for the same period in
2007, an increase of $5.6 million, or 429.1%.  In 2008, the Company
experienced a dramatic increase in the metrics it uses to monitor its loan
portfolio for increased risk of loss as evidenced by increases in classified,
non-performing, and impaired loans which grew to $44.1 million, $20.7 million,
and $20.2 million, at December 31, 2008, respectively from $29.4 million, $11.4
million, and $9.3 million at December 31, 2007, respectively.  In
addition, the Company’s loans internally classified as “substandard” and
“doubtful” increased to $14.2 million and $16.9 million as of December 31, 2008,
respectively, from $7.1 million and $9.5 million as of December 31, 2007,
respectively.  Of the total loans classified as either “substandard”
or “doubtful” at year-end 2008, $10.4 million were not included in the
non-performing loan total above.  The 2008 provision for loan losses
was impacted by deterioration in the underlying collateral values of certain
impaired commercial and construction real estate credits.  Throughout
2008, and particularly in the fourth quarter of 2008, the Company obtained
updated appraisals of the underlying collateral on certain large credits which
indicated the fair value had declined significantly from previously prepared
appraisals.  Accordingly, the Company increased its provision for loan
losses related to those collateral dependent impaired
loans.  Management assumed, based on the results of the updated
appraisals, that the collateral value for other similar impaired loans had also
deteriorated at a similar rate (outside of contradictory evidence) and reviewed
and adjusted the loss exposures for all collateral dependent impaired
loans.  As a result, the Company’s provision for loan losses was
significantly increased.  Also, the Company increased its exposure
related to unclassified loans based on an increase in charge-offs, past due
loans, classified loans, and a deterioration in the economic
environment.  During 2008, management internally conducted a full
review of its entire construction loan portfolio to identify other potential
problem credits in addition to outsourcing a loan review in the fourth quarter
of 2008 to a third party consultant to review other commercial
credits.  As a result of these efforts, in addition to the Company’s
ongoing system of monitoring and identifying problem credits, management
believes all problem credits have been appropriately classified and an
appropriate amount provided to reserve for probable incurred losses as of
December 31, 2008.


Statements
made in this section regarding the adequacy of the allowance for loan losses are
forward-looking statements that may or may not be accurate due to the
impossibility of predicting future events.  Because of uncertainties
inherent in the estimation process, management’s estimate of credit losses in
the loan portfolio and the related allowance may differ from actual
results.



















































































37
 Index





Table 8
provides the Company’s loan charge-off and recovery activity during the past
five years.





Table
8 - Summary of Loan Loss Experience





Year
      Ended in December 31,(Dollars
      in thousands)
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Allowance
      for loan losses at beginning of year
                  
                  $
                  6,316
                  
                  
                  $
                  5,654
                  
                  
                  $
                  5,920
                  
                  
                  $
                  4,523
                  
                  
                  $
                  4,034Acquired
      allowance of SCSB, July 1,2006
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  754
                  
                  
                  
                  -
                  
                  
                  
                  -Charge-offs:Residential
      real estate
                  
                  
                  (239
                  )
                  
                  
                  (173
                  )
                  
                  
                  (35
                  )
                  
                  
                  (83
                  )
                  
                  
                  (22
                  )Commercial
      real estate
                  
                  
                  (720
                  )
                  
                  
                  (44
                  )
                  
                  
                  (193
                  )
                  
                  
                  -
                  
                  
                  
                  (339
                  )Construction
                  
                  
                  (780
                  )
                  
                  
                  -
                  
                  
                  
                  (600
                  )
                  
                  
                  -
                  
                  
                  
                  -Commercial
      business
                  
                  
                  (1,080
                  )
                  
                  
                  (207
                  )
                  
                  
                  (138
                  )
                  
                  
                  (194
                  )
                  
                  
                  (245
                  )Home
      equity
                  
                  
                  (491
                  )
                  
                  
                  (187
                  )
                  
                  
                  (26
                  )
                  
                  
                  (198
                  )
                  
                  
                  (22
                  )Consumer
                  
                  
                  (503
                  )
                  
                  
                  (190
                  )
                  
                  
                  (362
                  )
                  
                  
                  (64
                  )
                  
                  
                  (52
                  )Total
                  
                  
                  (3,813
                  )
                  
                  
                  (801
                  )
                  
                  
                  (1,354
                  )
                  
                  
                  (539
                  )
                  
                  
                  (680
                  )Recoveries:Residential
      real estate
                  
                  
                  1
                  
                  
                  
                  14
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1Commercial
      real estate
                  
                  
                  4
                  
                  
                  
                  9
                  
                  
                  
                  9
                  
                  
                  
                  7
                  
                  
                  
                  24Construction
                  
                  
                  2
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Commercial
      business
                  
                  
                  7
                  
                  
                  
                  92
                  
                  
                  
                  26
                  
                  
                  
                  34
                  
                  
                  
                  18Home
      equity
                  
                  
                  4
                  
                  
                  
                  2
                  
                  
                  
                  -
                  
                  
                  
                  3
                  
                  
                  
                  -Consumer
                  
                  
                  100
                  
                  
                  
                  50
                  
                  
                  
                  37
                  
                  
                  
                  142
                  
                  
                  
                  21Total
                  
                  
                  118
                  
                  
                  
                  167
                  
                  
                  
                  72
                  
                  
                  
                  186
                  
                  
                  
                  64Net
      loan charge-offs
                  
                  
                  (3,695
                  )
                  
                  
                  (634
                  )
                  
                  
                  (1,282
                  )
                  
                  
                  (353
                  )
                  
                  
                  (616
                  )Provision
      for loan losses
                  
                  
                  6,857
                  
                  
                  
                  1,296
                  
                  
                  
                  262
                  
                  
                  
                  1,750
                  
                  
                  
                  1,105Allowance
      for loan losses at end of year
                  
                  $
                  9,478
                  
                  
                  $
                  6,316
                  
                  
                  $
                  5,654
                  
                  
                  $
                  5,920
                  
                  
                  $
                  4,523Ratios:Allowance
      for loan losses to total loans
                  
                  
                  1.50
                  %
                  
                  
                  0.99
                  %
                  
                  
                  0.92
                  %
                  
                  
                  1.14
                  %
                  
                  
                  0.99
                  %Net
      loan charge-offs to average loans
                  
                  
                  0.58
                  
                  
                  
                  0.10
                  
                  
                  
                  0.22
                  
                  
                  
                  0.07
                  
                  
                  
                  0.15Allowance
      for loan losses to non-performing loans
                  
                  
                  46
                  
                  
                  
                  56
                  
                  
                  
                  102
                  
                  
                  
                  108
                  
                  
                  
                  285





The
following table depicts management’s allocation of the allowance for loan losses
by loan type during the last five years.  Allowance funding and
allocation is based on management’s assessment of economic conditions, past loss
experience, loan volume, past-due history and other factors. Since these factors
and management's assumptions are subject to change, the allocation is not
necessarily indicative of future loan portfolio
performance.  Allocations of the allowance may be made for specific
loans or loan categories, but the entire allowance is available for any loan
that may be charged off.  Loan losses are charged against the
allowance when management deems a loan uncollectible.






























































38
 Index





Table 9 - Management's Allocation of the Allowance for Loan
Losses







As of December 31,2008
                
                
                2007
                
                
                2006
                
                
                2005
                
                
                2004(Dollars
      in thousands)
                
                Allowance
                
                
                Percent
      of Loans
                  to
      Total
                  Loans
                
                
                Allowance
                
                
                Percent
      of Loans
                  to
      Total
                  Loans
                
                
                Allowance
                
                
                Percent
      of Loans
                  to
      Total
                  Loans
                
                
                Allowance
                
                
                Percent
      of Loans
                  to
      Total
                  Loans
                
                
                Allowance
                
                
                Percent
      of Loans
                  to
      Total
                  LoansResidential
      Real Estate
                
                $
                644
                
                
                
                28.0
                %
                
                $
                681
                
                
                
                29.3
                %
                
                $
                479
                
                
                
                30.5
                %
                
                $
                336
                
                
                
                21.6
                %
                
                $
                325
                
                
                
                22.1
                %Commercial  Real
      Estate
                
                
                3,244
                
                
                
                32.7
                
                
                
                2,857
                
                
                
                30.2
                
                
                
                2,992
                
                
                
                29.2
                
                
                
                3,544
                
                
                
                36.0
                
                
                
                2,162
                
                
                
                40.9Construction
                
                
                3,492
                
                
                
                11.7
                
                
                
                199
                
                
                
                13.7
                
                
                
                48
                
                
                
                13.7
                
                
                
                23
                
                
                
                11.8
                
                
                
                17
                
                
                
                8.5Commercial
      Business
                
                
                1,119
                
                
                
                15.1
                
                
                
                1,716
                
                
                
                13.9
                
                
                
                1,501
                
                
                
                13.1
                
                
                
                1,407
                
                
                
                17.9
                
                
                
                1,533
                
                
                
                16.1Home
      Equity
                
                
                510
                
                
                
                9.6
                
                
                
                662
                
                
                
                9.5
                
                
                
                435
                
                
                
                10.2
                
                
                
                495
                
                
                
                11.2
                
                
                
                389
                
                
                
                10.9Consumer
                
                
                469
                
                
                
                2.9
                
                
                
                201
                
                
                
                3.4
                
                
                
                199
                
                
                
                3.3
                
                
                
                115
                
                
                
                1.5
                
                
                
                97
                
                
                
                1.5Total
                
                $
                9,478
                
                
                
                100.0
                %
                
                $
                6,316
                
                
                
                100.0
                %
                
                $
                5,654
                
                
                
                100.0
                %
                
                $
                5,920
                
                
                
                100.0
                %
                
                $
                4,523
                
                
                
                100.0
                %














Asset
Quality





Loans
(including impaired loans under Statements of Financial Accounting Standards 114
and 118) are placed on non-accrual status when they become past due 90 days or
more as to principal or interest.  When loans are placed on
non-accrual status, all unpaid accrued interest is reversed.  These
loans remain on non-accrual status until the loan becomes current or the loan is
deemed uncollectible and is charged off.  The Company defines impaired
loans to be those loans that management has determined it is probable, based on
current information and events, the Company will be unable to collect all
amounts due according to the contractual terms of the loan
agreement.  Loans individually classified as impaired increased to
$20.2 million at December 31, 2008 from $9.3 million at December 31,
2007.





Total
non-performing loans increased from $11.4 million at December 31, 2007 to $20.7
million at December 31, 2008 with total non-performing assets increasing to
$21.9 million from $11.9 million as of the same dates,
respectively.  Non-performing assets also include foreclosed real
estate that has been acquired through foreclosure or acceptance of a deed in
lieu of foreclosure.  Foreclosed real estate is carried at fair value
less estimated selling costs, and is actively marketed for sale.





In order
to identify and appropriately classify all impaired and other problem credits,
management undertook several initiatives.  In early 2008, the
Company’s risk management department conducted an extensive review of the
Company’s construction and development portfolio given the evidence of
deterioration in that portfolio beginning in late 2007.  Also, the
Company contracted with an independent consultant to review other commercial
loans in the portfolio in the fourth quarter of 2008.  As a result of
these reviews, the Company downgraded a few credits, none of which were
considered significant or severely problematic.  In addition, the
Company has strengthened its internal loan review and identification processes
through operational and structuring changes and additional senior management
oversight.  Based on these initiatives, management is confident that
all problem credits were appropriately identified and classified as of December
31, 2008.

















39
 Index





Table 10
provides the Company’s non-performing loan experience during the past five
years.





Table
10 - Non-Performing Assets





As
      of December 31,(Dollars
      in thousands)
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Loans
      on non-accrual status (1)
                  
                  $
                  20,702
                  
                  
                  $
                  11,134
                  
                  
                  $
                  5,566
                  
                  
                  $
                  5,498
                  
                  
                  $
                  1,588Loans
      past due 90 days or more and still accruing
                  
                  
                  -
                  
                  
                  
                  244
                  
                  
                  
                  -
                  
                  
                  
                  5
                  
                  
                  
                  -Total
      non-performing loans
                  
                  
                  20,702
                  
                  
                  
                  11,378
                  
                  
                  
                  5,566
                  
                  
                  
                  5,503
                  
                  
                  
                  1,588Other
      assets owned
                  
                  
                  1,147
                  
                  
                  
                  575
                  
                  
                  
                  457
                  
                  
                  
                  106
                  
                  
                  
                  106Total
      non-performing assets
                  
                  $
                  21,849
                  
                  
                  $
                  11,953
                  
                  
                  $
                  6,023
                  
                  
                  $
                  5,609
                  
                  
                  $
                  1,694Percentage
      of non-performing loans to total loans
                  
                  
                  3.27
                  %
                  
                  
                  1.79
                  %
                  
                  
                  0.91
                  %
                  
                  
                  1.06
                  %
                  
                  
                  0.35
                  %Percentage
      of non-performing assets to total loans
                  
                  
                  3.45
                  
                  
                  
                  1.88
                  
                  
                  
                  0.98
                  
                  
                  
                  1.08
                  
                  
                  
                  0.37





(1)
Impaired loans on non-accrual status are included in loans.  See Note
3 to the Consolidated Financial Statements for additional discussion on impaired
loans.








Investment
Securities





Table 11
sets forth the breakdown of the Company’s securities portfolio for the past five
years.





Table 11 - Securities Portfolio





December
      31,(Dollars
      in thousands)
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Securities
      Available for Sale:U.S.
      Government and federal agency
                  
                  $
                  -
                  
                  
                  $
                  6,077
                  
                  
                  $
                  29,972
                  
                  
                  $
                  10,921
                  
                  
                  $
                  4,739State
      and municipal
                  
                  
                  20,542
                  
                  
                  
                  13,312
                  
                  
                  
                  11,645
                  
                  
                  
                  6,449
                  
                  
                  
                  6,613Mortgage-backed
                  
                  
                  97,588
                  
                  
                  
                  73,252
                  
                  
                  
                  67,304
                  
                  
                  
                  66,752
                  
                  
                  
                  63,943Corporate
      bonds, including trust preferred securities
                  
                  
                  3,285
                  
                  
                  
                  6,583
                  
                  
                  
                  12,150
                  
                  
                  
                  14,471
                  
                  
                  
                  14,611Mutual
      Funds
                  
                  
                  244
                  
                  
                  
                  241
                  
                  
                  
                  240
                  
                  
                  
                  242
                  
                  
                  
                  246Total
      securities available for sale
                  
                  $
                  121,659
                  
                  
                  $
                  99,465
                  
                  
                  $
                  121,311
                  
                  
                  $
                  98,835
                  
                  
                  $
                  90,152














40
 Index


Table 12
sets forth the breakdown of the Company’s investment securities available for
sale by type and maturity as of December 31, 2008.  For analytical
purposes, the weighted average yield on state and municipal securities is
adjusted to a taxable equivalent adjustment basis to recognize the income tax
savings on tax-exempt securities.  A tax rate of 34% was used in
adjusting interest on tax-exempt securities to a fully taxable equivalent
(“FTE”) basis.





Table
12 - Investment Securities Available for Sale





As
      of December 31, 2008(Dollars
      in thousands)
                  
                  Amortized
                    Cost
                  
                  
                  Fair Value
                  
                  
                  Weighted
                    Average
                    YieldState
      and municipalWithin
      one year
                  
                  $
                  587
                  
                  
                  $
                  594
                  
                  
                  
                  5.11
                  %Over
      one through five years
                  
                  
                  2,124
                  
                  
                  
                  2,177
                  
                  
                  
                  5.85Over
      five through ten years
                  
                  
                  3,538
                  
                  
                  
                  3,493
                  
                  
                  
                  5.89Over
      ten years
                  
                  
                  14,677
                  
                  
                  
                  14,278
                  
                  
                  
                  6.29Total
      state and municipal
                  
                  
                  20,926
                  
                  
                  
                  20,542
                  
                  
                  
                  6.14Corporate
      bonds, including trust preferred securitiesOver
      ten years
                  
                  
                  5,696
                  
                  
                  
                  3,285
                  
                  
                  
                  3.94Total
      mutual funds
                  
                  
                  250
                  
                  
                  
                  244
                  
                  
                  
                  2.32
                  %Mortgage-backed
      securitiesOver
      one through five years
                  
                  
                  4,195
                  
                  
                  
                  4,248
                  
                  
                  
                  4.06Over
      five through ten years
                  
                  
                  16,037
                  
                  
                  
                  16,338
                  
                  
                  
                  4.25Over
      ten years
                  
                  
                  74,938
                  
                  
                  
                  77,002
                  
                  
                  
                  5.55Total
      mortgage-backed securities
                  
                  
                  95,170
                  
                  
                  
                  97,588
                  
                  
                  
                  5.27Total
      available for sale securities
                  
                  $
                  122,042
                  
                  
                  $
                  121,659
                  
                  
                  
                  5.37
                  %








Securities
available for sale increased from $99.5 million at December 31, 2007 to $121.7
million at December 31, 2008.  The increase in available for sale
securities was due primarily to purchases of $65.3 million, offset by
maturities, prepayments, and calls of $24.2 million and sales of $19.1 million
during 2008.The current
strategy for the securities portfolio is to maintain an intermediate average
life that remains relatively stable in a changing interest rate environment,
thus minimizing exposure to sustained increases in interest
rates.  The investment portfolio primarily consists of mortgage-backed
securities, securities issued by the United States government and its agencies,
securities issued by states and municipalities, and trust preferred
securities.  Mortgage-backed securities consist primarily of
obligations insured or guaranteed by Federal Home Loan Mortgage Corporation,
Federal National Mortgage Association, or Government National Mortgage
Association.





A
significant portion of the Company’s unrealized losses at December 31, 2008 were
related to six trust preferred securities comprised of debt of banks and
insurance companies.  The decrease in the fair value of these
securities is due primarily to the lack of transactions for these types of
securities as market participants are currently unwilling to conduct
transactions unless forced to do so.  See footnote 2 to the Company’s
financial statements for further discussion of the fair value of these
securities and management’s evaluation for other-than-temporary
impairment.




















41
 Index




Deposits





The
Company attracts deposits from the market areas it serves by offering a wide
range of deposit accounts with a variety of rate structures and
terms.  The Company uses interest rate risk simulations to assist
management in monitoring the Company’s deposit pricing, and periodically may
offer special rates on certificates of deposits and money market accounts to
maintain sufficient liquidity levels.  The Company relies primarily on
its retail and commercial sales staff and current customer relationships to
attract and retain deposits.  Market interest rates and competitive
pressures can significantly affect the Company’s ability to attract and retain
deposits.  The Company’s strategic plan includes continuing to grow
non-interest bearing accounts which contribute to higher levels of non-interest
income and net interest margin.





Total
deposits increased 5.2% to $603.2 million at December 31, 2008 compared to
$573.3 million at December 31, 2007, primarily due to increases in non-interest
bearing demand accounts, time deposit accounts, and savings accounts, offset by
decreases in money market and interest bearing demand
accounts.  Management attributes the increase in non-interest bearing
accounts to an emphasis on enhancing profitability of its commercial
relationships by evaluating the entire relationship, including the balance of
non-interest bearing deposits, when reviewing new and existing loans and their
terms.  It is the Company’s philosophy to price our new loans based on
the deposit relationship as well as the based on the risk of the credit and the
terms which has lead to increased non-interest bearing deposit
accounts.  Also, the Company continues to develop and enhance our
retail deposit product offerings in an effort to grow our retail deposit
base.  The decrease in our money market and interest bearing demand
accounts is primarily the result of the Company’s aggressive rate cutting in
lieu of the interest rate environment during 2008.  In 2008, the
Federal Open Market Committee reduced its target for federal funds
significantly.  As a result, the Company sought to adjust its cost on
its interest bearing deposits to match the downward interest rate trends which
led to a loss of accounts as certain customers have pursued higher interest
rates other financial institutions.





Table 13
provides a profile of the Company’s deposits during the past five
years.





Table
13 – Deposits





December
      31,(Dollars
      in thousands)
                    
                    2008
                    
                    
                    2007
                    
                    
                    2006
                    
                    
                    2005
                    
                    
                    2004Demand
      (NOW)
                    
                    $
                    91,641
                    
                    
                    $
                    94,939
                    
                    
                    $
                    63,542
                    
                    
                    $
                    36,496
                    
                    
                    $
                    38,243Money
      market accounts
                    
                    
                    101,032
                    
                    
                    
                    107,880
                    
                    
                    
                    115,248
                    
                    
                    
                    146,659
                    
                    
                    
                    114,332Savings
                    
                    
                    29,302
                    
                    
                    
                    26,971
                    
                    
                    
                    30,264
                    
                    
                    
                    22,507
                    
                    
                    
                    26,159Individual
      retirement accounts-certificates of deposit
                    
                    
                    28,981
                    
                    
                    
                    29,298
                    
                    
                    
                    27,054
                    
                    
                    
                    19,674
                    
                    
                    
                    18,771Certificates
      of deposit, $100,000 and over
                    
                    
                    97,440
                    
                    
                    
                    87,887
                    
                    
                    
                    95,069
                    
                    
                    
                    88,592
                    
                    
                    
                    65,705Other
      certificates of deposit
                    
                    
                    162,322
                    
                    
                    
                    146,515
                    
                    
                    
                    143,891
                    
                    
                    
                    103,335
                    
                    
                    
                    104,259Total
      interest bearing deposits
                    
                    
                    510,718
                    
                    
                    
                    493,490
                    
                    
                    
                    475,068
                    
                    
                    
                    417,263
                    
                    
                    
                    367,469Total
      non-interest bearing deposits
                    
                    
                    92,467
                    
                    
                    
                    79,856
                    
                    
                    
                    74,850
                    
                    
                    
                    47,573
                    
                    
                    
                    43,837Total
                    
                    $
                    603,185
                    
                    
                    $
                    573,346
                    
                    
                    $
                    549,918
                    
                    
                    $
                    464,836
                    
                    
                    $
                    411,306





























42
 Index





Other
Borrowings





The
Company’s other borrowings consist of repurchase agreements, lines of credit
with other financial institutions, federal funds purchased, which represent
overnight liabilities to non-affiliated financial institutions, and a structured
repurchase agreement.  While repurchase agreements are effectively
deposit equivalents, these arrangements consist of securities that are sold to
commercial customers under agreements to repurchase.  Other borrowings
increased $6.2 million from $72.8 million at December 31, 2007 to $79.0 million
at December 31, 2008 primarily due to an increase in repurchase agreements of
$5.6 million and an increase in line of credit borrowings of
$619,000.





Federal
Home Loan Bank Advances





FHLB
advances increased from $91.4 million at December 31, 2007 to $111.9 million at
December 31, 2008 as the Company utilized the proceeds to increase its available
liquidity on-hand and fund purchases of available for sale
securities.  These advances principally consist of putable (or
convertible) instruments that give the FHLB the option quarterly to put the
advance back to the Company, at which time the Company can prepay the advance
without penalty or can allow the advance to become variable adjusting to
three-month LIBOR (London Interbank Offer Rate).  However, there is a
substantial penalty if the Company prepays the advances prior to the FHLB
exercising its option.  In calculations provided by the FHLB to the
Company, three month LIBOR would have to rise by more than 300 basis points from
December 31, 2008 levels before the FHLB would exercise its put
option.  These advances have various maturities through 2010 (see Note
8 to the Consolidated Financial Statements for additional
information).  The Company does not anticipate that it will enter into
putable advances for the foreseeable future, but instead may use fixed or
variable rate advances to fund balance sheet growth as needed.





Liquidity




Liquidity
levels are adjusted in order to meet funding needs for deposit outflows,
repayment of borrowings, and loan commitments and to meet asset/liability
objectives.  The Bank’s primary sources of funds are deposits;
repayment of loans and mortgage-backed securities; Federal Home Loan Bank
advances; maturities of investment securities and other short-term investments;
and income from operations. While scheduled loan and mortgage-backed security
repayments are a relatively predictable source of funds, deposit flows and loan
and mortgage-backed security prepayments are greatly influenced by general
interest rates, economic conditions and competition.  Liquidity
management is both a daily and long term function of business
management.  If the Banks require funds beyond those generated
internally, as of December 31, 2008 the Banks had $46.7 million in additional
capacity under its borrowing agreements with the FHLB based on the Banks’
current FHLB stock holdings and approximately $39.0 million in federal funds
purchased with other financial institutions.  Also, the holding
company had $828,000 of additional borrowing capacity under a line of credit
agreement with another financial institution.  The holding company has
other sources of liquidity outside of the line of credit, primarily dividends
from its subsidiaries, YCB and SCSB which are limited by banking
regulations.  Currently, the Company can declare and pay dividends
without prior regulatory approval from its subsidiaries of
$799,000.  Subsequent to year end, YCB received notification from a
correspondent financial institution that one of its federal funds purchased
lines of credit had been canceled, reducing the Company’s federal funds
purchased availability by $10.0 million.  The decrease in capacity
does not currently impact YCB’s or the Company’s operations given YCB’s current
liquidity position.  The Company is currently negotiating with the
correspondent financial institution to have its line of credit
restored.  The Company anticipates it will have sufficient funds
available to meet current loan commitments and other credit
commitments.





Capital





Total
capital of the Company decreased to $62.6 million at December 31, 2008 from
$64.5 million as of December 31, 2007, a decrease of $1.9 million or
2.9%.  The decrease in capital was primarily due to dividends of $2.3
million.  Also contributing to the decrease in capital was an increase
in accumulated other comprehensive loss of $401,000 related to the decline in
the fair value of the Company’s securities available for sale and an increase in
the unrealized loss on pension benefits and the repurchase of 24,817 shares of
the Company’s common stock during the year for an aggregate cost of $400,000,
offset by net income of $821,000.








43
 Index




The
Company has actively been repurchasing shares of its common stock since May 21,
1999.  A net total of 621,365 shares at an aggregate cost of $10.7
million have been repurchased since that time under both the current and prior
repurchase plans.  The Company's Board of Directors authorized a share
repurchase plan in June 2007 under which a maximum of $5.0 million of the
Company's common stock could be purchased.  Through December 31, 2008,
a total of $1.6 million had been expended to purchase 85,098 shares under this
plan.





Regulatory
agencies measure capital adequacy within a framework that makes capital
requirements, in part, dependent on the risk inherent in the balance sheets of
individual financial institutions.  The Company and the Banks continue
to exceed the regulatory requirements for Tier I, Tier I leverage and total
risk-based capital ratios (see Note 13 to the Consolidated Financial
Statements).





Off
Balance Sheet Arrangements





The
Company uses off balance sheet financial instruments, such as commitments to
make loans, credit lines and letters of credit to meet customer financing
needs.  These agreements provide credit or support the credit of
others and usually have expiration dates but may expire without being
used.  In addition to credit risk, the Company also has liquidity risk
associated with these commitments as funding for these obligations could be
required immediately.  The contractual amount of these financial
instruments with off balance sheet risk was as follows at December 31,
2008:





(Dollars
      in thousands)Commitments
      to make loans
                  
                  $
                  2,084Unused
      lines of credit
                  
                  
                  122,296Standby
      letters of credit
                  
                  
                  5,737Total
                  
                  $
                  130,117








Aggregate
Contractual Obligations





As
      of December 31, 2008
                
                Total
                
                
                Less
      than
                  1 year
                
                
                1-3 years
                
                
                3-5 years
                
                
                More
      than
                  5 years(Dollars
      in thousands)Time
      deposits
                
                $
                288,744
                
                
                $
                238,867
                
                
                $
                46,406
                
                
                $
                3,234
                
                
                $
                237Repurchase
      agreements
                
                
                69,811
                
                
                
                60,011
                
                
                
                -
                
                
                
                9,800
                
                
                
                -FHLB
      borrowings
                
                
                111,943
                
                
                
                31,991
                
                
                
                74,952
                
                
                
                5,000
                
                
                
                -Subordinated
      debentures
                
                
                17,000
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                17,000Lease
      commitments
                
                
                4,017
                
                
                
                626
                
                
                
                1,100
                
                
                
                936
                
                
                
                1,355Total
                
                $
                491,515
                
                
                $
                331,495
                
                
                $
                122,458
                
                
                $
                18,970
                
                
                $
                18,592











Time
deposits represent certificates of deposit held by the Company.





FHLB
advances represent the amounts that are due the FHLB and consist of $67.0
million in convertible fixed rate advances and $44.9 million in fixed rate
advance.  With respect to the convertible fixed rate advances, the
FHLB has the quarterly right to require the Company to choose either conversion
of the fixed rate to a variable rate tied to the three month LIBOR index or
prepayment of the advance without penalty.  There is a substantial
penalty if the Company prepays the advances before FHLB exercises its
right.  Management does not expect these advances to be converted in
the near term.  In 2009, $20.0 million of the convertible fixed rate
advances mature which carry a weighted average cost of 5.90%.  The
Company anticipates utilizing interest bearing deposits in other financial
institutions to pay the advances which, given management’s current assumptions
about available liquidity and the interest rate environment, should increase net
interest income by approximately $550,000 in 2009.





Subordinated
debentures represent the scheduled maturities of subordinated debentures issued
to trusts formed by the Company in connection with the issuance of trust
preferred securities.





Lease
commitments represent the total minimum lease payments under noncancelable
operating leases, before considering renewal options that generally are
present.








44
 Index




Item
7A.  Quantitative And Qualitative Disclosures About Market
Risk





Asset/liability
management is the process of balance sheet control designed to ensure safety and
soundness and to maintain liquidity and regulatory capital standards while
maintaining acceptable net interest income.  Interest rate risk is the
exposure to adverse changes in net interest income as a result of market
fluctuations in interest rates.  Management continually monitors
interest rate and liquidity risk so that it can implement appropriate funding,
investment, and other balance sheet strategies.  Management considers
market interest rate risk to be one of the Company’s most significant ongoing
business risk considerations.





The
Company currently contracts with an independent third party consulting firm to
measure its interest rate risk position.  The consulting firm utilizes
an earnings simulation model to analyze net interest income
sensitivity.  Current balance sheet amounts, current yields and costs,
corresponding maturity and repricing amounts and rates, other relevant
information, and certain assumptions made by management are combined with
gradual movements in interest rates of 200 basis points up and 200 basis points
down within the model to estimate their combined effects on net interest income
over a one-year horizon.  In 2008, the Federal Open Market Committee
lowered its target for the federal funds rate to 0-25 bps.  A majority
of our loans are indexed to prime, therefore, the Company has excluded an
evaluation of the effect on net interest income assuming a decrease in interest
rates as further reductions in the prime rate are extremely
unlikely.  Interest rate movements are spread equally over the
forecast period of one year.  The Company feels that using gradual
interest rate movements within the model is more representative of future rate
changes than instantaneous interest rate shocks.  The Company does not
project growth in amounts for any balance sheet category when constructing the
model because of the belief that projected growth can mask current interest rate
risk imbalances over the projected horizon.  The Company believes that
the changes made to its interest rate risk measurement process have improved the
accuracy of results of the process.  Consequently, the Company
believes that it has better information on which to base asset and liability
allocation decisions going forward.





Assumptions
based on the historical behavior of the Company’s deposit rates and balances in
relation to changes in interest rates are incorporated into the
model.  These assumptions are inherently uncertain and, as a result,
the model cannot precisely measure future net interest income or precisely
predict the impact of fluctuations in market interest rates on net interest
income.  The Company continually monitors and updates the assumptions
as new information becomes available.  Actual results will differ from
the model's simulated results due to timing, magnitude and frequency of interest
rate changes, and actual variations from the managerial assumptions utilized
under the model, as well as changes in market conditions and the application and
timing of various management strategies.





The base
scenario represents projected net interest income over a one year forecast
horizon exclusive of interest rate changes to the simulation
model.  Given a gradual 200 basis point increase in the projected
yield curve used in the simulation model (“Up 200 Scenario”), it is estimated
that as of December 31, 2008 the Company’s net interest income would decrease by
an estimated 2.21%, or $571,000, over the one year forecast
horizon.  However, considering reasonable growth assumptions, the
Company expects that net interest income will grow over the forecast
horizon.  As of December 31, 2007, in the Up 200 Scenario the Company
estimated that net interest income would decrease 0.15%, or $36,000, over a one
year forecast horizon ending December 31, 2008.  Given a gradual 200
basis point decrease in the projected yield curve used in the simulation model
(“Down 200 Scenario”), it is estimated that as of December 31, 2007, the
Company’s estimated net interest income would decrease 0.16%, or $37,000, over a
one year forecast horizon ending December 31, 2008.














45
 Index




The
projected results are within the Company’s asset/liability management policy
limits, which states that the negative impact to net interest income should not
exceed 7% in a 200 basis point decrease or increase in the projected yield curve
over a one year forecast horizon.  The forecast results are heavily
dependent on the assumptions regarding changes in deposit rates; the Company can
minimize the reduction in net interest income in a period of rising interest
rates to the extent that it can curtail raising deposit rates during this
period.  The Company continues to explore transactions and strategies
to both increase its net interest income and minimize its interest rate
risk.





The
interest sensitivity profile of the Company at any point in time will be
affected by a number of factors.  These factors include the mix of
interest sensitive assets and liabilities as well as their relative repricing
schedules.  Such profile is also influenced by market interest rates,
deposit growth, loan growth, and other factors.





The
following tables, which are representative only and are not precise measurements
of the effect of changing interest rates on the Company’s net interest income in
the future, illustrate the Company’s estimated one year net interest income
sensitivity profile based on the above referenced asset/liability model as of
December 31, 2008 and 2007, respectively:








Interest
Rate Sensitivity For 2008








(Dollars in thousands)
                      
                      Base
                      
                      
                      Gradual
                        Increase
                        In
      Interest
                        Rates
      of 200
                        Basis
      PointsProjected
      interest income:Loans
                      
                      $
                      36,673
                      
                      
                      $
                      38,562Investments
                      
                      
                      5,666
                      
                      
                      
                      5,975FHLB
      and FRB stock
                      
                      
                      432
                      
                      
                      
                      432Interest-bearing
      deposits in other financial
                        institutions
                      
                      
                      1
                      
                      
                      
                      148Federal
      funds sold
                      
                      
                      11
                      
                      
                      
                      185Total
      interest income
                      
                      
                      42,783
                      
                      
                      
                      45,302Projected
      interest expense:Deposits
                      
                      
                      10,729
                      
                      
                      
                      12,914Federal
      funds purchased, line of credit and
                        Repurchase
      agreements
                      
                      
                      740
                      
                      
                      
                      1,437FHLB
      advances
                      
                      
                      4,809
                      
                      
                      
                      4,875Subordinated
      debentures
                      
                      
                      623
                      
                      
                      
                      765Total
      interest expense
                      
                      
                      16,901
                      
                      
                      
                      19,991Net
      interest income
                      
                      $
                      25,882
                      
                      
                      $
                      25,311Change
      from base
                      
                      
                      
                      
                      
                      $
                      (571
                      )%
      Change from base
                      
                      
                      
                      
                      
                      
                      (2.21
                      )%


























46
 Index





Interest
Rate Sensitivity For 2007





(Dollars in thousands)
                
                Gradual
                  Decrease
                  In
      Interest
                  Rates
      of 200
                  Basis
      Points
                
                
                Base
                
                
                Gradual
                  Increase
                  In
      Interest
                  Rates
      of 200
                  Basis
      PointsProjected
      interest income:Loans
                
                $
                41,263
                
                
                $
                43,909
                
                
                $
                46,469Investments
                
                
                4,648
                
                
                
                4,886
                
                
                
                5,027FHLB
      and FRB stock
                
                
                377
                
                
                
                377
                
                
                
                377Interest-bearing
      deposits in other
                  financial
      institutions
                
                
                29
                
                
                
                49
                
                
                
                68Federal
      funds sold
                
                
                844
                
                
                
                1,152
                
                
                
                1,433Total
      interest income
                
                
                47,161
                
                
                
                50,373
                
                
                
                53,374Projected
      interest expense:Deposits
                
                
                15,079
                
                
                
                17,216
                
                
                
                19,233Federal
      funds purchased, line of
                  credit
      and Repurchase agreements
                
                
                2,122
                
                
                
                2,864
                
                
                
                3,589FHLB
      advances
                
                
                5,092
                
                
                
                5,216
                
                
                
                5,340Other
      borrowings
                
                
                175
                
                
                
                204
                
                
                
                233Subordinated
      debentures
                
                
                1,041
                
                
                
                1,184
                
                
                
                1,326Total
      interest expense
                
                
                23,509
                
                
                
                26,684
                
                
                
                29,721Net
      interest income
                
                $
                23,652
                
                
                $
                23,689
                
                
                $
                23,653Change
      from base
                
                $
                (37
                )
                
                
                
                
                
                $
                (36
                )%
      Change from base
                
                
                (0.16
                )%
                
                
                
                
                
                
                (0.15
                )%




































































47
 Index








COMMUNITY
BANK SHARES OF INDIANA, INC.


New
Albany, Indiana





FINANCIAL STATEMENTS


December
31, 2008, 2007, and 2006














REPORT OF INDEPENDENT REGISTERED PUBLIC
      ACCOUNTING FIRM
                  49FINANCIAL STATEMENTSCONSOLIDATED BALANCE
SHEETS
                  50CONSOLIDATED
      STATEMENTS OF INCOME
                  51CONSOLIDATED
      STATEMENTS OF CHANGES INSHAREHOLDERS’ EQUITY
                  52CONSOLIDATED
      STATEMENTS OF CASH FLOWS
                  54NOTES TO
      CONSOLIDATED FINANCIAL STATEMENTS
                  56










48
 Index








REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM








Board of
Directors and Shareholders


Community
Bank Shares of Indiana, Inc.


New
Albany, Indiana








We have
audited the accompanying consolidated balance sheets of Community Bank Shares of
Indiana, Inc. as of December 31, 2008 and 2007, and the related
consolidated statements of income, changes in shareholders’ equity, and cash
flows for each of the three years in the period ended December 31,
2008.  These financial statements are the responsibility of the
Company’s management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  The
Company is not required to have, nor were we engaged to perform, an audit of its
internal control over financial reporting.  Our audit included
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Company’s
internal control over financial reporting.  Accordingly, we express no
opinion.  An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial
statements.  An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation.  We believe
that our audits provide a reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Community Bank Shares of
Indiana, Inc. as of December 31, 2008 and 2007, and the results of its
operations and its cash flows for each of the three years in the period ended
December 31, 2008 in conformity with United States generally accepted accounting
principles.














/s/ Crowe Horwath LLP





Louisville,
Kentucky


March 30,
2009





49
 Index
 COMMUNITY
BANK SHARES OF INDIANA, INC.


CONSOLIDATED BALANCE SHEETS


December
31


(In
thousands, except share amounts)








2008
                  
                  
                  2007ASSETSCash
      and due from financial institutions
                  
                  $
                  19,724
                  
                  
                  $
                  14,570Interest-bearing
      deposits in other financial institutions
                  
                  
                  45,749
                  
                  
                  
                  13,943Securities
      available for sale
                  
                  
                  121,659
                  
                  
                  
                  99,465Loans
      held for sale
                  
                  
                  308
                  
                  
                  
                  757Loans,
      net of allowance for loan losses of $9,478 and $6,316
                  
                  
                  623,103
                  
                  
                  
                  629,732Federal
      Home Loan Bank and Federal Reserve stock
                  
                  
                  8,472
                  
                  
                  
                  8,096Accrued
      interest receivable
                  
                  
                  3,163
                  
                  
                  
                  3,537Premises
      and equipment, net
                  
                  
                  15,128
                  
                  
                  
                  15,147Company
      owned life insurance
                  
                  
                  17,745
                  
                  
                  
                  16,911Goodwill
                  
                  
                  15,335
                  
                  
                  
                  15,335Other
      intangible assets
                  
                  
                  2,492
                  
                  
                  
                  2,899Other
      assets
                  
                  
                  4,485
                  
                  
                  
                  3,176$
                  877,363
                  
                  
                  $
                  823,568LIABILITIES
      AND SHAREHOLDERS’ EQUITYDepositsNon
      interest-bearing
                  
                  $
                  92,467
                  
                  
                  $
                  79,856Interest-bearing
                  
                  
                  510,718
                  
                  
                  
                  493,490Total
      deposits
                  
                  
                  603,185
                  
                  
                  
                  573,346Other
      borrowings
                  
                  
                  78,983
                  
                  
                  
                  72,796Federal
      Home Loan Bank advances
                  
                  
                  111,943
                  
                  
                  
                  91,376Subordinated
      debentures
                  
                  
                  17,000
                  
                  
                  
                  17,000Accrued
      interest payable
                  
                  
                  1,705
                  
                  
                  
                  1,956Other
      liabilities
                  
                  
                  1,948
                  
                  
                  
                  2,629Total
      liabilities
                  
                  
                  814,764
                  
                  
                  
                  759,103Commitments
      and contingent liabilities (Note 16)
                  
                  
                  -
                  
                  
                  
                  -Shareholders’
      equityPreferred
      stock, without par value; 5,000,000 shares authorized;
                    none
      issued
                  
                  
                  -
                  
                  
                  
                  -Common
      stock, $.10 par value per share; 10,000,000 shares
                    authorized;
      3,863,942 shares issued; 3,242,577 and 3,260,904
                    outstanding
      in 2008 and 2007, respectively
                  
                  
                  386
                  
                  
                  
                  386Additional
      paid-in capital
                  
                  
                  45,313
                  
                  
                  
                  45,035Retained
      earnings
                  
                  
                  28,268
                  
                  
                  
                  29,723Accumulated
      other comprehensive loss
                  
                  
                  (640
                  )
                  
                  
                  (239
                  )Treasury
      stock, at cost (2008- 621,365 shares, 2007- 603,038
shares)
                  
                  
                  (10,728
                  )
                  
                  
                  (10,440
                  )Total
      shareholders’ equity
                  
                  
                  62,599
                  
                  
                  
                  64,465$
                  877,363
                  
                  
                  $
                  823,568




















50
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.





CONSOLIDATED STATEMENTS OF INCOME


Years
ended December 31


(In
thousands, except per share amounts)











2008
                  
                  
                  2007
                  
                  
                  2006Interest
      and dividend incomeLoans,
      including fees
                  
                  $
                  38,833
                  
                  
                  $
                  46,030
                  
                  
                  $
                  41,360Taxable
      securities
                  
                  
                  4,798
                  
                  
                  
                  4,711
                  
                  
                  
                  4,738Tax-exempt
      securities
                  
                  
                  697
                  
                  
                  
                  510
                  
                  
                  
                  467Federal
      Home Loan Bank and Federal Reserve dividends
                  
                  
                  338
                  
                  
                  
                  381
                  
                  
                  
                  397Interest-bearing
      deposits in other financial institutions
                  
                  
                  241
                  
                  
                  
                  144
                  
                  
                  
                  13244,907
                  
                  
                  
                  51,776
                  
                  
                  
                  47,094Interest
      expenseDeposits
                  
                  
                  13,529
                  
                  
                  
                  18,783
                  
                  
                  
                  16,933Other
      borrowings
                  
                  
                  1,403
                  
                  
                  
                  2,824
                  
                  
                  
                  3,054Federal
      Home Loan Bank advances
                  
                  
                  5,605
                  
                  
                  
                  5,492
                  
                  
                  
                  5,066Subordinated
      debentures
                  
                  
                  916
                  
                  
                  
                  1,296
                  
                  
                  
                  94221,453
                  
                  
                  
                  28,395
                  
                  
                  
                  25,995Net
      interest income
                  
                  
                  23,454
                  
                  
                  
                  23,381
                  
                  
                  
                  21,099Provision
      for loan losses
                  
                  
                  6,857
                  
                  
                  
                  1,296
                  
                  
                  
                  262Net
      interest income after provision for loan losses
                  
                  
                  16,597
                  
                  
                  
                  22,085
                  
                  
                  
                  20,837Non-interest
      incomeService
      charges on deposit accounts
                  
                  
                  3,356
                  
                  
                  
                  3,187
                  
                  
                  
                  2,954Commission
      income
                  
                  
                  194
                  
                  
                  
                  172
                  
                  
                  
                  107Net
      gain (loss) on sales of available for sale securities
                  
                  
                  364
                  
                  
                  
                  (41
                  )
                  
                  
                  -Mortgage
      banking income
                  
                  
                  167
                  
                  
                  
                  236
                  
                  
                  
                  322Earnings
      on company owned life insurance
                  
                  
                  734
                  
                  
                  
                  678
                  
                  
                  
                  573Change
      in fair value and cash settlement of interest rate swaps
                  
                  
                  180
                  
                  
                  
                  (1,248
                  )
                  
                  
                  (1,061
                  )Interchange
      income
                  
                  
                  811
                  
                  
                  
                  704
                  
                  
                  
                  533Gain
      on disposition of equity stock
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  18Other
      income
                  
                  
                  281
                  
                  
                  
                  439
                  
                  
                  
                  2876,087
                  
                  
                  
                  4,127
                  
                  
                  
                  3,733Non-interest
      expenseSalaries
      and employee benefits
                  
                  
                  12,125
                  
                  
                  
                  11,466
                  
                  
                  
                  10,345Occupancy
                  
                  
                  2,169
                  
                  
                  
                  1,760
                  
                  
                  
                  1,479Equipment
                  
                  
                  1,535
                  
                  
                  
                  1,446
                  
                  
                  
                  1,188Data
      processing
                  
                  
                  1,931
                  
                  
                  
                  2,183
                  
                  
                  
                  2,162Marketing
      and advertising
                  
                  
                  738
                  
                  
                  
                  583
                  
                  
                  
                  527Legal
      and professional service fees
                  
                  
                  1,153
                  
                  
                  
                  1,383
                  
                  
                  
                  1,097Other
      expense
                  
                  
                  2,903
                  
                  
                  
                  2,983
                  
                  
                  
                  2,31822,554
                  
                  
                  
                  21,804
                  
                  
                  
                  19,116Income
      before income taxes
                  
                  
                  130
                  
                  
                  
                  4,408
                  
                  
                  
                  5,454Income
      tax  (benefit) expense
                  
                  
                  (691
                  )
                  
                  
                  905
                  
                  
                  
                  1,343Net
      income
                  
                  $
                  821
                  
                  
                  $
                  3,503
                  
                  
                  $
                  4,111Earnings
      per share:Basic
                  
                  $
                  0.25
                  
                  
                  $
                  1.05
                  
                  
                  $
                  1.36Diluted
                  
                  $
                  0.25
                  
                  
                  $
                  1.04
                  
                  
                  $
                  1.35








See
accompanying notes.
 51
 Index
 COMMUNITY
BANK SHARES OF INDIANA, INC.


CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’
EQUITY


Years
ended December 31


(In
thousands except per share amounts)














Common
      Stock
                
                
                Additional
                
                
                
                
                
                Accumulated
                  Other
                
                
                
                
                
                TotalShares
                  Outstanding
                
                
                Amount
                
                
                Paid-In
                  Capital
                
                
                Retained
                  Earnings
                
                
                Comprehensive
                  Loss
                
                
                Treasury
                  Stock
                
                
                Shareholders’
                  EquityBalance
      at January 1, 2006
                
                
                2,605,544
                
                
                
                300
                
                
                
                24,971
                
                
                
                26,329
                
                
                
                (2,838
                )
                
                
                (5,987
                )
                
                
                42,775Comprehensive
      income:Net
      income
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                4,111
                
                
                
                
                
                
                
                -
                
                
                
                4,111Change
      in securities available for sale, net ofreclassification
      and tax effects
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                631
                
                
                
                -
                
                
                
                631Change
      in unrealized gains (losses),interest
      rate swap net of reclassificationand
      tax effects
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                390
                
                
                
                -
                
                
                
                390Change
      in minimum pension liability,net
      of tax effects
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                76
                
                
                
                -
                
                
                
                76Total
      comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                5,208Cash
      dividends declared ($.640 per share)
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (1,921
                )
                
                
                -
                
                
                
                -
                
                
                
                (1,921
                )Purchase
      of treasury stock
                
                
                (30,000
                )
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (685
                )
                
                
                (685
                )Acquisition
      of The Bancshares, Inc.
                
                
                862,875
                
                
                
                86
                
                
                
                19,722
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                19,808Stock
      award expense
                
                
                -
                
                
                
                -
                
                
                
                261
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                261Stock
      options exercised
                
                
                1,100
                
                
                
                -
                
                
                
                (2
                )
                
                
                -
                
                
                
                -
                
                
                
                17
                
                
                
                15Tax
      benefit for stock options exercised
                
                
                -
                
                
                
                -
                
                
                
                80
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                80Balance
      at December 31, 2006
                
                
                3,439,519
                
                
                
                386
                
                
                
                45,032
                
                
                
                28,519
                
                
                
                (1,741
                )
                
                
                (6,655
                )
                
                
                65,541Comprehensive
      income:Net
      income
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                3,503
                
                
                
                
                
                
                
                -
                
                
                
                3,503Change
      in securities available for sale, net ofreclassification
      and tax effects
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                752
                
                
                
                -
                
                
                
                752Change
      in unrealized gains (losses),interest
      rate swap net of reclassificationand
      tax effects
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                632
                
                
                
                -
                
                
                
                632








52
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.




CONSOLIDATED
STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY


Years
ended December 31


(In
thousands except per share amounts)














Common
      Stock
                
                
                Additional
                
                
                
                
                
                Accumulated
                  Other
                
                
                
                
                
                TotalShares
                  Outstanding
                
                
                Amount
                
                
                Paid-In
                  Capital
                
                
                Retained
                  Earnings
                
                
                Comprehensive
                  Loss
                
                
                Treasury
                  Stock
                
                
                Shareholders’
                  EquityUnrealized
      loss on pension benefits,net
      of tax effects
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (36
                )
                
                
                -
                
                
                
                (36
                )Total
      comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                4,851Reclassification
      of unrealized loss on interestrate
      swap, net of tax effect (see Note 14 to theConsolidated
      Financial Statements)
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                154
                
                
                
                -
                
                
                
                154Cash
      dividends declared ($.685 per share)
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (2,299
                )
                
                
                -
                
                
                
                -
                
                
                
                (2,299
                )Purchase
      of treasury stock
                
                
                (186,090
                )
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (3,904
                )
                
                
                (3,904
                )Stock
      award expense
                
                
                -
                
                
                
                -
                
                
                
                122
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                122Issuance
      of performance unit shares
                
                
                7,475
                
                
                
                -
                
                
                
                (119
                )
                
                
                -
                
                
                
                -
                
                
                
                119
                
                
                
                -Balance
      at December 31, 2007
                
                
                3,260,904
                
                
                $
                386
                
                
                $
                45,035
                
                
                $
                29,723
                
                
                $
                (239
                )
                
                $
                (10,440
                )
                
                $
                64,465Comprehensive
      income:Net
      income
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                821
                
                
                
                
                
                
                
                -
                
                
                
                821Change
      in securities available for sale, net ofreclassification
      and tax effects
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (261
                )
                
                
                -
                
                
                
                (261
                )Unrealized
      loss on pension benefits,net
      of tax effects
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (140
                )
                
                
                -
                
                
                
                (140
                )Total
      comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                420Cash
      dividends declared ($.70 per share)
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (2,276
                )
                
                
                -
                
                
                
                -
                
                
                
                (2,276
                )Purchase
      of treasury stock
                
                
                (24,817
                )
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (400
                )
                
                
                (400
                )Issuance
      of treasury stock under dividend
                  reinvestment
      plan
                
                
                6,490
                
                
                
                -
                
                
                
                (31
                )
                
                
                -
                
                
                
                -
                
                
                
                112
                
                
                
                81Stock
      award expense
                
                
                -
                
                
                
                -
                
                
                
                309
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                309Balance
      at December 31, 2008
                
                
                3,242,577
                
                
                $
                386
                
                
                $
                45,313
                
                
                $
                28,268
                
                
                $
                (640
                )
                
                $
                (10,728
                )
                
                $
                62,599


See
accompanying notes.
 53
 Index
 COMMUNITY
BANK SHARES OF INDIANA, INC.


CONSOLIDATED STATEMENTS OF CASH FLOWS


Years
ended December 31


(In
thousands)











2008
                  
                  
                  2007
                  
                  
                  2006Cash
      flows from operating activitiesNet
      income
                  
                  $
                  821
                  
                  
                  $
                  3,503
                  
                  
                  $
                  4,111Adjustments
      to reconcile net income tonet cash from operating
      activities:Provision
      for loan losses
                  
                  
                  6,857
                  
                  
                  
                  1,296
                  
                  
                  
                  262Depreciation
      and amortization
                  
                  
                  1,863
                  
                  
                  
                  1,660
                  
                  
                  
                  1,287Net
      accretion of securities
                  
                  
                  (120
                  )
                  
                  
                  (106
                  )
                  
                  
                  9Net
      (gain) loss on sales of available for sale securities
                  
                  
                  (364
                  )
                  
                  
                  41
                  
                  
                  
                  -Mortgage
      loans originated for sale
                  
                  
                  (13,589
                  )
                  
                  
                  (12,032
                  )
                  
                  
                  (17,418
                  )Proceeds
      from mortgage loan sales
                  
                  
                  14,235
                  
                  
                  
                  12,370
                  
                  
                  
                  18,466Net
      gain on sales of mortgage loans
                  
                  
                  (197
                  )
                  
                  
                  (187
                  )
                  
                  
                  (262
                  )Earnings
      on company owned life insurance
                  
                  
                  (734
                  )
                  
                  
                  (678
                  )
                  
                  
                  (573
                  )FHLB
      stock dividends
                  
                  
                  (16
                  )
                  
                  
                  -
                  
                  
                  
                  (37
                  )Share
      based compensation expense
                  
                  
                  309
                  
                  
                  
                  122
                  
                  
                  
                  332Net
      (gain) loss on sale of other real estate
                  
                  
                  22
                  
                  
                  
                  48
                  
                  
                  
                  (20
                  )Gain
      on disposition of equity stock
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (18
                  )Net
      (gain) loss on disposition of premises and equipment
                  
                  
                  (4
                  )
                  
                  
                  19
                  
                  
                  
                  -Net
      change inAccrued
      interest receivable
                  
                  
                  374
                  
                  
                  
                  431
                  
                  
                  
                  (503
                  )Accrued
      interest payable
                  
                  
                  (251
                  )
                  
                  
                  (222
                  )
                  
                  
                  862Other
      assets
                  
                  
                  (438
                  )
                  
                  
                  (415
                  )
                  
                  
                  484Other
      liabilities
                  
                  
                  (893
                  )
                  
                  
                  (890
                  )
                  
                  
                  (351
                  )Net
      cash from operating activities
                  
                  
                  7,875
                  
                  
                  
                  4,960
                  
                  
                  
                  6,631Cash
      flows from investing activitiesAcquisition
      of The Bancshares, Inc., net
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (795
                  )Net
      change in interest-bearing deposits
                  
                  
                  (31,806
                  )
                  
                  
                  (12,733
                  )
                  
                  
                  164Available
      for sale securities:Sales
                  
                  
                  19,098
                  
                  
                  
                  10,937
                  
                  
                  
                  2,990Purchases
                  
                  
                  (65,381
                  )
                  
                  
                  (21,868
                  )
                  
                  
                  (18,980
                  )Maturities,
      prepayments and calls
                  
                  
                  24,181
                  
                  
                  
                  34,100
                  
                  
                  
                  18,969Loan
      originations and payments, net
                  
                  
                  (3,149
                  )
                  
                  
                  (23,387
                  )
                  
                  
                  (7,914
                  )Purchase
      of premises and equipment, net
                  
                  
                  (1,524
                  )
                  
                  
                  (1,504
                  )
                  
                  
                  (2,248
                  )Proceeds
      from the sale of premises and equipment
                  
                  
                  10
                  
                  
                  
                  -
                  
                  
                  
                  -Proceeds
      from the sale of other real estate
                  
                  
                  2,318
                  
                  
                  
                  252
                  
                  
                  
                  416Purchase
      of FHLB and Federal Reserve stock
                  
                  
                  (376
                  )
                  
                  
                  (769
                  )
                  
                  
                  -Redemption
      of FHLB and Federal Reserve stock
                  
                  
                  16
                  
                  
                  
                  91
                  
                  
                  
                  2,011Investment
      in cash surrender value of life insurance
                  
                  
                  (100
                  )
                  
                  
                  -
                  
                  
                  
                  (2,050
                  )Net
      cash from investing activities
                  
                  
                  (56,713
                  )
                  
                  
                  (14,881
                  )
                  
                  
                  (7,437
                  )











See
accompanying notes.
 54
 Index
 COMMUNITY
BANK SHARES OF INDIANA, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


Years
ended December 31


(In
thousands)














2008
                  
                  
                  2007
                  
                  
                  2006Cash
      flows from financing activitiesNet
      change in deposits
                  
                  $
                  29,900
                  
                  
                  $
                  23,509
                  
                  
                  $
                  (18,784
                  )Net
      change in other borrowings
                  
                  
                  6,187
                  
                  
                  
                  (11,539
                  )
                  
                  
                  36,600Proceeds
      from Federal Home Loan Bank advances
                  
                  
                  77,000
                  
                  
                  
                  113,000
                  
                  
                  
                  128,300Repayment
      of Federal Home Loan Bank advances
                  
                  
                  (56,500
                  )
                  
                  
                  (114,500
                  )
                  
                  
                  (143,800
                  )Proceeds
      from issuance of subordinated debentures
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  10,000Exercise
      of stock options
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  15Purchase
      of treasury stock
                  
                  
                  (400
                  )
                  
                  
                  (3,904
                  )
                  
                  
                  (685
                  )Tax
      benefit of stock options exercised
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  80Cash
      dividends paid
                  
                  
                  (2,195
                  )
                  
                  
                  (2,299
                  )
                  
                  
                  (1,921
                  )Net
      cash from financing activities
                  
                  
                  53,992
                  
                  
                  
                  4,267
                  
                  
                  
                  9,805Net
      change in cash and due from banks
                  
                  
                  5,154
                  
                  
                  
                  (5,654
                  )
                  
                  
                  8,999Cash
      and due from banks at beginning of year
                  
                  
                  14,570
                  
                  
                  
                  20,224
                  
                  
                  
                  11,225Cash
      and due from banks at end of year
                  
                  $
                  19,724
                  
                  
                  $
                  14,570
                  
                  
                  $
                  20,224Supplemental
      cash flow information:Interest
      paid
                  
                  $
                  21,704
                  
                  
                  $
                  28,617
                  
                  
                  $
                  25,133Income
      taxes paid, net of refunds
                  
                  
                  334
                  
                  
                  
                  1,274
                  
                  
                  
                  1,145Supplemental
      noncash disclosures:Transfers
      from loans to foreclosed assets
                  
                  
                  3,292
                  
                  
                  
                  592
                  
                  
                  
                  506Sale
      and financing of foreclosed assets
                  
                  
                  286
                  
                  
                  
                  167
                  
                  
                  
                  249Issuance
      of treasury shares under dividend reinvestment plan
                  
                  
                  81
                  
                  
                  
                  -
                  
                  
                  
                  -





See
accompanying notes.
 55
 Index
 COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006


NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Nature of Operations and
Principles of Consolidation:  The consolidated financial
statements include Community Bank Shares of Indiana, Inc. and its wholly owned
subsidiaries, Your Community Bank (YCB) and The Scott County State Bank (SCSB),
collectively referred to as “the Company”.  YCB utilizes three
wholly-owned subsidiaries to manage its investment portfolio.  CBSI
Holdings, Inc. and CBSI Investments, Inc. are Nevada corporations which jointly
own CBSI Investment Portfolio Management, LLC, a Nevada limited liability
corporation which holds and manages the Bank’s investment
securities.  YCB established a new Community Development Entity (CDE)
subsidiary in July 2002 named CBSI Development Fund, Inc.  The CDE
enables YCB to participate in the federal New Markets Tax Credit (NMTC)
Program.  The NMTC Program is administered by the Community
Development Financial Institutions Fund of the United States Treasury and is
designed to promote investment in low-income communities by providing a tax
credit over seven years for equity investments in CDE’s.  During June
2004 and June 2006, the Company completed placements of floating rate
subordinated debentures through Community Bank Shares (IN) Statutory Trust I and
Trust II (Trusts), trusts formed by the Company.  Because the Trusts
are not consolidated with the Company, pursuant to FASB Interpretation No. 46,
the financial statements reflect the subordinated debt issued by the Company to
the Trusts.  Intercompany balances and transactions are eliminated in
consolidation.  On July 1, 2006, the Company completed its acquisition
of The Bancshares, Inc. and its wholly-owned subsidiary SCSB; subsequently, the
Company liquidated The Bancshares, Inc.





The
Company provides financial services through its offices in Floyd, Clark and
Scott counties in Indiana, and Jefferson and Nelson counties in
Kentucky.  Its primary deposit products are checking, savings, and
term certificate accounts, and its primary lending products are residential
mortgage, commercial, and installment loans.  Substantially all loans
are secured by specific items of collateral including business assets, consumer
assets, and commercial and residential real estate.  Commercial loans
are expected to be repaid from cash flow from operations of
businesses.  There are no significant concentrations of loans to any
one industry or customer.  However, the customers’ ability to repay
their loans is dependent on the real estate and general economic conditions in
the area.





Use of
Estimates:  To prepare financial statements in conformity with
the United States generally accepted accounting principles management makes
estimates and assumptions based on available information.  These
estimates and assumptions affect the amounts reported in the financial
statements and the disclosures provided, and actual results could
differ.  The allowance for loan losses, valuation of goodwill and
other intangible assets, fair value of securities and deferred tax assets are
particularly subject to change.





Cash
Flows:  Cash and cash equivalents include cash and non-interest
bearing deposits with other financial institutions with maturities less than 90
days.  Net cash flows are reported for interest-bearing deposits in
other financial institutions, loans, deposits, and short-term
borrowings.





Interest-bearing Deposits in
Other Financial Institutions:  Interest-bearing deposits in
other financial institutions mature within one year, are carried at
cost.





Securities:  Securities
are classified as available for sale when they might be sold before
maturity.  Securities available for sale are carried at fair value,
with unrealized holding gains and losses reported in other comprehensive income,
net of tax.








56
 Index
 COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006


NOTE 1 - SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES (Continued)





Interest
income includes amortization of purchase premium or
discount.  Premiums and discounts on securities are amortized on the
level-yield method without anticipating prepayments except for mortgage backed
securities where prepayments are anticipated.  Gains and losses on
sales are recorded on the trade date and determined using the specific
identification method.





Declines
in the fair value of securities below their cost that are other than temporary
are reflected as realized losses.  In estimating other-than-temporary
losses, management considers:   the length of time and extent
that fair value has been less than cost, the financial condition and near term
prospects of the issuer, the Company’s ability and intent to hold the security
for a period sufficient to allow for any anticipated recovery in fair value, and
whether there has been an adverse change in expected cash flows.





Mortgage Banking
Activities:  Mortgage loans originated and intended for sale in
the secondary market are carried at the lower of aggregate cost or market
value.  To deliver closed loans to the secondary market and to control
its interest rate risk prior to sale, the Company enters into agreements to sell
loans.  The aggregate market value of mortgage loans held for sale
considers the price of the sales contracts.  Loan commitments related
to the origination of mortgage loans held for sale and the corresponding sales
contracts are considered derivative instruments.  The Company’s
commitments are for fixed rate mortgage loans, generally lasting 60 days and are
at market rates when initiated.  The Company had commitments to
originate $480,000 and $231,000 in loans and an equal amount of corresponding
sales contracts at December 31, 2008 and 2007.  The impact of
accounting for these instruments as derivatives was not material and
substantially all of the gain on sale generated from mortgage banking activities
continues to be recorded when closed loans are delivered into the sales
contracts.  The adoption of SAB 109 was not material to the Company’s
accounting for mortgage banking income.





The
Company sells loans on a servicing released basis.  The Company sold
loans previous to 2006 on a servicing retained basis.  Servicing
assets were recorded on loans sold with servicing retained and were capitalized
in other assets and expensed into other income against service fee income
inproportion
to, and over the period of, estimated net servicing
revenues.  Impairment is evaluated based on the fair value of the
assets, using groupings of the underlying loans as to interest rates and then,
secondarily, as to geographic and prepayment characteristics.  Fair
value is determined using prices for similar assets with similar
characteristics, when available, or based upon discounted cash flows using
market-based assumptions.  Any impairment of a grouping is reported as
a valuation allowance, to the extent that fair value is less than the
capitalized amount for a grouping.





Servicing
fee income, which is reported on the income statement as mortgage banking
income, is recorded for fees earned for servicing loans.  The fees are
based on a contractual percentage of the outstanding principal.  The
amortization of mortgage servicing rights is netted against mortgage servicing
fee income.  Servicing fees, net of amortization, totaled $39,000,
$49,000 and $60,000 for the years ended December 31, 2008, 2007 and 2006. The
Company recorded an impairment charge of $69,000, $0, and $0 for the years ended
December 31, 2008, 2007 and 2006.  Late fees and ancillary fees
related to loan servicing are not material.





Loans:  Loans
that management has the intent and ability to hold for the foreseeable future or
until maturity or payoff are reported at the principal balance outstanding, net
of deferred loan fees and costs and an allowance for loan losses.





57
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006




NOTE 1 - SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES (Continued)





Interest
income is accrued on the unpaid principal balance.  Loan origination
fees, net of certain direct origination costs, are deferred and recognized in
interest income using the level-yield method without anticipating
prepayments.  Interest income on commercial, mortgage and consumer
loans is discontinued at the time the loan is 90 days
delinquent.  Consumer loans are typically charged-off no later than
120 days past due.  In all cases, loans are placed on non-accrual or
charged-off at an earlier date if collection of principal or interest is
considered doubtful.  All interest accrued but not received for loans
placed on non-accrual is reversed against interest income.  Interest
received on such loans is accounted for on the cash-basis or cost-recovery
method, until qualifying for return to accrual.  Loans are returned to
accrual status when all the principal and interest amounts contractually due are
brought current and future payments are reasonably assured.





Allowance for Loan
Losses:  The allowance for loan losses is a valuation allowance
for probable incurred credit losses, increased by the provision for loan losses
and decreased by charge-offs less recoveries.  Management estimates
the allowance balance required using past loan loss experience, the nature and
volume of the portfolio, information about specific borrower situations and
estimated collateral values, economic conditions, and other
factors.  Allocations of the allowance may be made for specific loans,
but the entire allowance is available for any loan that, in management’s
judgment, should be charged-off.  Loan losses are charged against the
allowance when management believes the uncollectibility of a loan balance is
confirmed.





The
allowance consists of specific and general components.  The specific
component relates to loans that are individually classified as impaired or loans
otherwise classified as substandard, doubtful, or loss.  The general
component covers non-classified loans and is based on historical loss experience
adjusted for current factors.





A loan is
impaired when full payment under the loan terms is not
expected.  Commercial and commercial real estate loans are
individually evaluated for impairment.  If a loan is impaired, a
portion of the allowance is allocated so that the loan is reported, net, at the
present value of estimated future cash flows using the loan’s existing rate or
at the fair value of collateral if repayment is expected solely from the
collateral.  Smaller balance homogeneous loans, such as consumer and
residential real estate, are collectively evaluated for impairment, and
accordingly, they are not separately identified for impairment
disclosure.





Premises and
Equipment:  Land is carried at cost.  Premises and
equipment are stated at cost less accumulated depreciation.  Buildings
and related components are depreciated using the straight-line method with
useful lives ranging from 7 to 40 years.  Furniture, fixtures, and
equipment are depreciated using the straight-line method with useful lives
ranging from 2 to 10 years.  Leasehold improvements are amortized over
the shorter of their economic lives or the term of the lease.





Federal Home Loan Bank
(FHLB) and Federal Reserve Stock:  FHLB and Federal Reserve
stock are required investments for institutions that are members of the Federal
Reserve and FHLB systems.  The required investment in the common stock
is based on a predetermined formula.  Federal Reserve and FHLB stock
are carried at cost, classified as restricted securities, and are periodically
evaluated for impairment.  Because the stocks are viewed as long term
investments, impairment is based on ultimate recovery of par
value.  Both cash and stock dividends are reported as
income.











58
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006




NOTE 1 - SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES (Continued)





Company Owned Life
Insurance The Company has purchased
life insurance policies on certain key executives.  In accordance with
EITF 06-5, Company owned life insurance is recorded at the amount that can be
realized under the insurance contract at the balance sheet date, which is the
cash surrender value adjusted for other charges or other amounts due that are
probable at settlement.





Goodwill and Other
Intangible Assets:  Goodwill results from business acquisitions
and represents the excess of the purchase price over the fair value of acquired
tangible assets and liabilities and identifiable intangible
assets.  Goodwill is assessed at least annually for impairment and any
such impairment is recognized in the period identified.





Other
intangible assets consist of core deposit intangible and loan customer
intangible assets arising from bank acquisitions.  They are initially
measured at fair value and then are amortized on an accelerated method over
their estimated useful lives of 10 years.





Long-term
Assets:Premises and equipment,
core deposit intangibles, loan customer intangibles and other long-term assets
are reviewed for impairment when events indicate their carrying amount may not
be recoverable from future undiscounted cash flows.  If impaired, the
assets are recorded at fair value.





Foreclosed
Assets:  Assets acquired through or instead of loan foreclosure
are initially recorded at fair value less costs to sell when acquired,
establishing a new cost basis.  If fair value declines, a valuation
allowance is recorded through expense.  Costs after acquisition are
expensed.  Foreclosed assets amounted to $1.2 million and $575,000 at
year-end 2008 and 2007, respectively, and are included in other assets in the
consolidated balance sheets.





Repurchase
Agreements:  Repurchase agreement liabilities, included in
other borrowings, represent amounts advanced by various
customers.  Securities are pledged to cover these liabilities, which
are not covered by federal deposit insurance.





Equity:  Stock
dividends in excess of 20% are reported by transferring the par value of the
stock issued from retained earnings to common stock.  Stock dividends
of 20% or less are reported by transferring the fair value, as of the
ex-dividend date, of the stock issued from retained earnings to common stock and
additional paid-in capital.  Fractional share amounts are paid in cash
with a reduction in retained earnings.  Treasury stock is carried at
cost.





Benefit
Plans:  Pension expense is the net of service and interest
cost, return on plan assets, and amortization of gains and losses not
immediately recognized.  The Company adopted FAS 158 in 2006, and
accordingly, recognizes the overfunded or underfunded status of its defined
benefit postretirement plan as an asset or liability in its balance sheet and
recognizes changes in the funded status in the year in which the changes occur
through comprehensive income.  Profit sharing and 401k plan expense is
the amount contributed determined by formula.






















59
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE 1 – SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES (Continued)







Stock-Based
Compensation:  Compensation cost is recognized for stock
options and restricted stock awards issued to employees, based on the fair value
of these awards at the date of grant.  Compensation cost for
performance unit awards is based on both the fair market value of the shares at
the grant date and the Company’s stock price at the end of the reporting
cycle.  A Black-Scholes model is utilized to estimate the fair value
of stock options, while the market price of the Company’s common stock at the
date of grant is used for restricted stock and sixty-five percent of the
performance unit awards.  The remaining thirty-five percent of the
total performance unit awards are paid in cash and is therefore classified as a
liability, with total compensation cost changing as the Company’s stock price
changes.  Compensation cost is recognized over the required service
period, generally defined as the vesting period.  For awards with
graded vesting, compensation cost is recognized on a straight-line basis over
the requisite service period for the entire award.


Income
Taxes:  Income tax expense is the total of the current year
income tax due or refundable and the change in deferred tax assets and
liabilities.  Deferred tax assets and liabilities are the expected
future tax amounts for the temporary differences between carrying amounts and
tax bases of assets and liabilities, computed using enacted tax
rates.  A valuation allowance, if needed, reduces deferred tax assets
to the amount expected to be realized.





The
Company adopted FASB Interpretation 48, Accounting for Uncertainty in Income
Taxes (“FIN 48”), as of January 1, 2007.  A tax position
is recognized as a benefit only if it is "more likely than not" that the tax
position would be sustained in a tax examination, with a tax examination being
presumed to occur.  The amount recognized is the largest amount of tax
benefit that is greater than 50% likely of being realized on
examination.  For tax positions not meeting the "more likely than not"
test, no tax benefit is recorded.  The adoption had no affect on the
Company’s financial statements.





The
Company recognizes interest and/or penalties related to income tax matters in
income tax expense.





Loan Commitments and Related
Financial Instruments:  Financial instruments include
off-balance sheet credit instruments, such as commitments to make loans and
standby letters of credit, issued to meet customer-financing
needs.  The face amount for these items represents the exposure to
loss, before considering customer collateral or ability to
repay.  Such financial instruments are recorded when they are
funded.












































60
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE 1 - SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES (Continued)




Derivatives:  Derivative
financial instruments are recognized as assets or liabilities at fair
value.  The Company's derivatives consist mainly of interest rate swap
agreements, which are used as part of its asset liability management to help
manage interest rate risk.  The Company does not use derivatives for
trading purposes.





At the
start of a derivative contract, the Company designates the derivative as one of
three types based on the Company's intentions and belief as to likely
effectiveness as a hedge.  These three types are a hedge of the fair
value of a recognized asset or liability of an unrecognized firm commitment
(“fair value hedge”), a hedge of a forecasted transaction or the variability of
cash flows to be received or paid related to a recognized asset or liability
(“cash flow hedge”), or an instrument with no hedging designation (“stand-alone
derivative”).  For a fair value hedge, the gain or loss on the
derivative, as well as the offsetting loss or gain on the hedged item, are
recognized in current earnings as fair values change. For a cash flow hedge, the
gain or loss on the derivative is reported in other comprehensive income and is
reclassified into earnings in the same periods during which the hedged
transaction affects earnings.  For both types of hedges, derivative
gains and losses that are not effective in hedging the changes in fair value or
expected cash flows of the hedged item are recognized immediately in current
earnings.  Changes in the fair value of stand-alone derivatives that
do not qualify for hedge accounting are reported currently in earnings, as
noninterest income.





Net cash
settlements on derivatives that qualify for hedge accounting are recorded in
interest income or interest expense, based on the item being
hedged.  Net cash settlements on derivatives that do not qualify for
hedge accounting are reported in noninterest income. Cash flows on hedges are
classified in the cash flow statement the same as the cash flows of the items
being hedged.





The
Company formally documents the relationship between derivatives and hedged
items, as well as the risk-management objective and the strategy for undertaking
hedge transactions.  This documentation includes linking fair value or
cash flow hedges to specific assets and liabilities on the balance sheet or to
specific firm commitments or forecasted transactions.  The Company
also formally assesses, both at the hedge’s inception and on an ongoing basis,
whether the derivative instruments that are used are highly effective in
offsetting changes in fair values or cash flows of the hedged items. The Company
discontinues hedge accounting when it determines that the derivative is no
longer effective in offsetting changes in the fair value or cash flows of the
hedged item, the derivative is settled or terminates, a hedged forecasted
transaction is no longer probable, a hedged firm commitment is no longer firm,
or treatment of the derivative as a hedge is no longer appropriate or
intended.





When
hedge accounting is discontinued, later changes in fair value of the derivative
are recorded as noninterest income.  When a fair value hedge is
discontinued, the hedged asset or liability is no longer adjusted for changes in
fair value and the existing basis adjustment is amortized or accreted over the
remaining life of the asset or liability. When a cash flow hedge is discontinued
but the hedged cash flows or forecasted transaction is still expected to occur,
gains or losses that were accumulated in other comprehensive income are
amortized into earnings over the same periods which the hedged transactions will
affect earnings.





During
2007, the Company determined that its use of hedge accounting for its interest
rate swap was in error.  See Note 14 for additional
details.











61
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006




NOTE 1 - SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES (Continued)





Earnings Per Common
Share:  Basic earnings per common share is net income divided
by the weighted average number of common shares outstanding during the
period.  Diluted earnings per common share include the dilutive effect
of additional potential common shares issuable under stock
options.  Earnings and dividends per share are restated for stock
splits and dividends through the date of issuance of the financial
statements.





Comprehensive
Income:  Comprehensive income consists of net income and other
comprehensive income.  Other comprehensive income, recognized as
separate components of equity, includes changes in the following
items:  unrealized gains and losses on securities available for sale,
unrealized gains and losses on interest rate swaps that qualify for hedge
accounting (cash flow hedges), and a minimum pension liability.





Loss
Contingencies:  Loss contingencies, including claims and legal
actions arising in the ordinary course of business, are recorded as liabilities
when the likelihood of loss is probable and an amount or range of loss can be
reasonably estimated.  Management does not believe there are such
matters that will have a material effect on the consolidated financial
statements.





Restrictions on
Cash:  Cash on hand or on deposit with the Federal Reserve Bank
of $1.4 million was required to meet regulatory reserve and clearing
requirements at year-end 2008 and 2007.  Beginning in October 2008,
balances on deposit with the Federal Reserve began earning
interest.





Dividend
Restriction:  Banking regulations require maintaining certain
capital levels and may limit the dividends paid by the bank subsidiaries to the
holding company or by the holding company to shareholders, as more fully
described in a separate note.





Fair Value of Financial
Instruments:  Fair values of financial instruments are
estimated using relevant market information and other assumptions, as more fully
disclosed in a separate note.  Fair value estimates involve
uncertainties and matters of significant judgment regarding interest rates,
credit risk, prepayments, and other factors, especially in the absence of broad
markets for particular items.  Changes in assumptions or in market
conditions could significantly affect the estimates.





Operating
Segments:  While the chief decision-makers monitor the revenue
streams of the various products and services, the identifiable segments are not
material and operations are managed and financial performance is evaluated on a
Company-wide basis.  Accordingly, all of the financial service
operations are considered by management to be aggregated in one reportable
operating segment.






































62
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE 1 - SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES(Continued)





Adoption of New Accounting
Standards:




In
September 2006, the FASB issued Statement No. 157, Fair ValueMeasurements(FAS
157).  This Statement defines fair value, establishes a framework for
measuring fair value and expands disclosures about fair value
measurements.  This Statement establishes a fair value hierarchy about
the assumptions used to measure fair value and clarifies assumptions about risk
and the effect of a restriction on the sale or use of an asset.  The
standard was effective for fiscal years beginning after November 15,
2007.  In February 2008, the FASB issued Staff Position (FSP)
157-2,Effective Date of FASB
Statement No. 157.This FSP delays the effective date of FAS
157 for all nonfinancial assets and nonfinancial liabilities, except those that
are recognized or disclosed at fair value on a recurring basis (at least
annually) to fiscal years beginning after November 15, 2008, and interim periods
within those fiscal years. The impact of adoption was not
material.  In October 2008, the FASB issued Staff Position (FSP)
157-3, Determining the Fair
Value of a Financial Asset when the Market for That Asset Is Not
Active.  This FSP clarifies the application of FAS 157 in a
market that is not active.  FSP 157-3 was used to determine the fair
value of trust preferred securities (see Footnote 2).




In
February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities.  The standard provides
companies with an option to report selected financial assets and liabilities at
fair value and establishes presentation and disclosure requirements designed to
facilitate comparisons between companies that choose different measurement
attributes for similar types of assets and liabilities.  The new
standard was effective for the Company on January 1, 2008.  The
Company did not elect the fair value option for any financial assets or
financial liabilities as of January 1, 2008 or subsequently.





In
September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-4,
Accounting for Deferred
Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life
Insurance Arrangements.  This issue requires that a liability
be recorded during the service period when a split-dollar life insurance
agreement continues after participants’ employment or retirement.  The
required accrued liability will be based on either the post-employment benefit
cost for the continuing life insurance or based on the future death benefit
depending on the contractual terms of the underlying agreement.  This
issue was effective for fiscal years beginning after December 15,
2007.  The impact of adoption was not material.





On
November 5, 2007, the SEC issued Staff Accounting Bulletin No. 109, Written Loan Commitments Recorded at
Fair Value through Earnings(“SAB 109”). Previously, SAB 105, Application of Accounting Principles to Loan
Commitments, stated that in measuring the fair value of a derivative loan
commitment, a company should not incorporate the expected net future cash flows
related to the associated servicing of the loan. SAB 109 supersedes SAB 105 and
indicates that the expected net future cash flows related to the associated
servicing of the loan should be included in measuring fair value for all written
loan commitments that are accounted for at fair value through
earnings.  SAB 105 also indicated that internally-developed intangible
assets should not be recorded as part of the fair value of a derivative loan
commitment, and SAB 109 retains that view.  SAB 109 was effective for
derivative loan commitments issued or modified in fiscal quarters beginning
after December 15, 2007.  The impact of adoption was not
material.










63
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006




NOTE 1 - SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES(Continued)







In
December 2007, the SEC issued SAB No. 110, which expresses the views of the SEC
regarding the use of a “simplified” method, as discussed in SAB No. 107, in
developing an estimate of expected term of “plain vanilla” share options in
accordance with SFAS No. 123(R), Share-Based Payment.  The SEC
concluded that a company could, under certain circumstances, continue to use the
simplified method for share option grants after December 31,
2007.  The Company does not use the simplified method for share
options and therefore SAB No. 110 has no impact on the Company’s consolidated
financial statements.




On
January 12, 2009, the FASB issued FSP No. EITF 99-20-1, Amendements to the Impairment and
Interest Income Measurement Guidance of EITF Issue No.
99-20.  FSP EITF 99-20-1 changed the guidance for the
determination of whether an impariment of certain non-investment grade,
beneficial interests in securitized financial interests assets is considered
other-than-temporary.  The adoption of FSP EITF 99-20-1, effective
December 31, 2008, did not have a material impact on the Company’s consolidated
financial statements.





Effect of Newly Issued But
Not Yet Effective Accounting Standards:





In
December 2007, the FASB issued FAS No. 141 (revised 2007), Business
Combinations (“FAS 141(R)”), which establishes principles and requirements for
how an acquirer recognizes and measures in its financial statements the
identifiable assets acquired, the liabilities assumed, and any noncontrolling
interest in an acquiree, including the recognition and measurement of goodwill
acquired in a business combination.  FAS No. 141(R) is effective for
fiscal years beginning on or after December 15, 2008.  Earlier adoption is
prohibited.  The adoption of this standard is not expected to have a
material effect on the Corporation’s results of operations or financial
position.





In
December 2007, the FASB issued SFAS No. 160,“Noncontrolling Interest in
Consolidated Financial Statements, an amendment of ARB
No. 51”  (“SFAS No. 160”), which will change the
accounting and reporting for minority interests, which will be recharacterized
as noncontrolling interests and classified as a component of equity within the
consolidated balance sheets. FAS No. 160 is effective as of the beginning
of the first fiscal year beginning on or after December 15,
2008.  Earlier adoption is prohibited and the Corporation does not
expect the adoption of FAS No. 160 to have a significant impact on its results
of operations or financial position.





In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities, an amendment of SFAS No. 133”. FAS No. 161 amends and
expands the disclosure requirements of SFAS No. 133 for derivative instruments
and hedging activities. FAS No. 161 requires qualitative disclosure about
objectives and strategies for using derivative and hedging instruments,
quantitative disclosures about fair value amounts of the instruments and gains
and losses on such instruments, as well as disclosures about credit-risk
features in derivative agreements.  FAS No. 161 is effective for
financial statements issued for fiscal years and interim periods beginning after
November 15, 2008, with early application encouraged.  The adoption of
this standard is not expected to have a material effect on the Corporation’s
results of operations or financial position.




Reclassifications:  Some
items in the prior years’ financial statements were reclassified to conform to
the current presentation.











64
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006




NOTE
2 – SECURITIES





The fair
value of available for sale securities and the related gross unrealized gains
and losses recognized in accumulated other comprehensive loss were as
follows.








Fair
                  Value
                
                
                Gross
                  Unrealized
                  Gains
                
                
                Gross
                  Unrealized
                  Losses2008
                
                (In
      thousands)State
      and municipal
                
                $
                20,542
                
                
                $
                174
                
                
                $
                (558
                )Mortgaged-backed
      agencies
                
                
                97,588
                
                
                
                2,430
                
                
                
                (12
                )Corporate
      bonds, including trust preferred securities
                
                
                3,285
                
                
                
                -
                
                
                
                (2,411
                )Mutual
      funds
                
                
                244
                
                
                
                -
                
                
                
                (6
                )Total
                
                $
                121,659
                
                
                $
                2,604
                
                
                $
                (2,987
                )








Fair
                  Value
                
                
                Gross
                  Unrealized
                  Gains
                
                
                Gross
                  Unrealized
                  Losses2007
                
                (In
      thousands)U.S.
      Government and federal agency
                
                $
                6,077
                
                
                $
                83
                
                
                $
                -State
      and municipal
                
                
                13,312
                
                
                
                281
                
                
                
                (1
                )Mortgaged-backed
      agencies
                
                
                73,252
                
                
                
                519
                
                
                
                (568
                )Corporate
      bonds, including trust preferred securities
                
                
                6,583
                
                
                
                -
                
                
                
                (297
                )Mutual
      funds
                
                
                241
                
                
                
                -
                
                
                
                (9
                )Total
                
                $
                99,465
                
                
                $
                883
                
                
                $
                (875
                )








Sales of
available for sale securities were as follows.







2008
                  
                  
                  2007
                  
                  
                  2006(In
      thousands)Proceeds
                  
                  $
                  19,098
                  
                  
                  $
                  10,937
                  
                  
                  $
                  2,990Gross
      gains
                  
                  
                  364
                  
                  
                  
                  2
                  
                  
                  
                  -Gross
      losses
                  
                  
                  -
                  
                  
                  
                  (43
                  )
                  
                  
                  -








The tax
provision (benefit) applicable to these net realized gains (losses) amounted to
$ 124,000, $(14,000) and $0, respectively.




65
 Index
 COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006


NOTE 2 – SECURITIES(Continued)





Contractual
maturities of available for sale securities at year-end 2008 were as
follows.  Mortgage-backed agency securities and mutual funds which do
not have a single maturity date are shown separately.





Fair
                      Value(In
      thousands)Due
      in one year or less
                    
                    $
                    594Due
      from one to five years
                    
                    
                    2,177Due
      from five to ten years
                    
                    
                    3,493Due
      after ten years
                    
                    
                    17,563Mortgage-backed
      agencies
                    
                    
                    97,588Mutual
      Funds
                    
                    
                    244Total
                    
                    $
                    121,659








Securities
pledged at year-end 2008 and 2007 had a carrying amount of $81.5 million and
$76.0 million to secure public deposits, repurchase agreements and Federal Home
Loan Bank advances.





At year
end 2008 and 2007, there were no holdings of securities of any one issuer, other
than the U.S. Government and its agencies, in an amount greater than 10% of
shareholders’ equity.





Securities
with unrealized losses at year end 2008 and 2007, aggregated by investment
category and length of time that individual securities have been in a continuous
loss position are as follows (in thousands):






Less than 12 Months
                      
                      
                      12 Months or More
                      
                      
                      Total(In
      thousands)2008
                      
                      Fair
                        Value
                      
                      
                      Unrealized
                        Loss
                      
                      
                      Fair
                        Value
                      
                      
                      Unrealized
                        Loss
                      
                      
                      Fair
                        Value
                      
                      
                      Unrealized
                        LossState
      and municipal
                      
                      $
                      13,174
                      
                      
                      $
                      (558
                      )
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      13,174
                      
                      
                      $
                      (558
                      )Mortgaged-backed
      agencies
                      
                      
                      2,241
                      
                      
                      
                      (8
                      )
                      
                      
                      560
                      
                      
                      
                      (4
                      )
                      
                      
                      2,801
                      
                      
                      
                      (12
                      )Corporate
      bonds, including trust preferred securities
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      3,285
                      
                      
                      
                      (2,411
                      )
                      
                      
                      3,285
                      
                      
                      
                      (2,411
                      )Mutual
      funds
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      244
                      
                      
                      
                      (6
                      )
                      
                      
                      244
                      
                      
                      
                      (6
                      )Total
      temporarily impaired
                      
                      $
                      15,415
                      
                      
                      $
                      (566
                      )
                      
                      $
                      4,089
                      
                      
                      $
                      (2,421
                      )
                      
                      $
                      19,504
                      
                      
                      $
                      (2,987
                      )


























66
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE 2 – SECURITIES(Continued)


Less than 12 Months
                      
                      
                      12 Months or More
                      
                      
                      Total(In
      thousands)2007
                      
                      Fair
                        Value
                      
                      
                      Unrealized
                        Loss
                      
                      
                      Fair
                        Value
                      
                      
                      Unrealized
                        Loss
                      
                      
                      Fair
                        Value
                      
                      
                      Unrealized
                        LossState
      and municipal
                      
                      $
                      886
                      
                      
                      $
                      (1
                      )
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      886
                      
                      
                      $
                      (1
                      )Mortgaged-backed
      agencies
                      
                      
                      1,796
                      
                      
                      
                      (1
                      )
                      
                      
                      39,934
                      
                      
                      
                      (567
                      )
                      
                      
                      41,730
                      
                      
                      
                      (568
                      )Corporate
      bonds, including trust preferred securities
                      
                      
                      5,589
                      
                      
                      
                      (290
                      )
                      
                      
                      995
                      
                      
                      
                      (7
                      )
                      
                      
                      6,584
                      
                      
                      
                      (297
                      )Mutual
      funds
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      241
                      
                      
                      
                      (9
                      )
                      
                      
                      241
                      
                      
                      
                      (9
                      )Total
      temporarily impaired
                      
                      $
                      8,271
                      
                      
                      $
                      (292
                      )
                      
                      $
                      41,170
                      
                      
                      $
                      (583
                      )
                      
                      $
                      49,441
                      
                      
                      $
                      (875
                      )





All
unrealized losses are reviewed on at least a quarterly basis to determine
whether the losses are other than temporary and are reviewed more frequently
when economic or market concerns warrant such evaluation. Consideration is given
to the length of time and the extent to which the fair value has been less than
cost, the financial condition and near-term prospects of the issuer, and our
intent and ability to retain the investment in the issuer for a period of time
sufficient to allow for any anticipated recovery in fair value. In analyzing an
issuer’s financial condition, we may consider whether the securities are issued
by the federal government or its agencies, whether downgrades by bond rating
agencies have occurred, the results of reviews of the issuer’s financial
condition, and, in the case of our trust preferred securities, the present value
of the estimated remaining cash flows.




A
significant portion of the Company’s unrealized losses at December 31, 2008 were
related to six trust preferred securities.  The decrease in the fair
value of these securities is due primarily to the lack of transactions for these
types of securities as market participants are currently unwilling to conduct
transactions unless forced to do so.  Management reviewed these
securities in accordance with FSP EITF 99-20-1, “Amendements to the Impairment
and Interest Income Measurement Guidance of EITF Issue No. 99-20” (“FSP EITF
99-20-1”), which requires the Company to determine whether the fair value
of the beneficial interest has declined below the reference amount and if the
decline is other than temporary.  If the holder’s determination of the
expected cash flows has adversely changed, an other-than-temporary impairment is
considered to have occurred.
 
 Management
utilized a discounted cash flow analysis to determine if there was
other-than-temporary impairment related to these 6 securities.  The
cash flow models were provided by our investment advisors and were used to
determine if the expected cash flows as of December 31, 2008 were consistent
with the expected cash flows at the date of purchase.  The cash flow
models included assumptions related to prepayments and anticipated deferrals and
defaults for the underlying issuers comprising each issuance.  The
results of the analysis indicated there had not been an adverse change in the
expected cash flows for each of the trust preferred securities we
own.  Management also reviewed other relevant information in our
assessment including:  multiple broker quotes, the duration of the
unrealized loss, the severity of the decline in fair value, financial
information of the underlying issuers within each trust preferred security, and
the ability and intent of the Company to hold the security until
recovery.  Also, the Company reviewed known and anticipated deferrals
and defaults of the underlying issues within the trust preferred securities as
of December 31, 2008 and subsequent to year-end.  Based on review of
the cash flow analyses and the other factors identified above, management
determined the Company’s trust preferred security were not
other-than-temporarily impaired and therefore did not recognize a loss into
income.





67
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006




NOTE 2 – SECURITIES(Continued)





Certain
securities within the Company’s state and municipal portfolio have unrealized
losses as of December 31, 2008 which have not been recognized into earnings.
Management has reviewed the municipal portfolio and determined that a majority
maintain investment grade ratings while five of the remaining securities have
not been graded by a rating agency due to downgrades of the companies insuring
the issuance which did not impact management’s estimate of credit worthiness of
the issuer.  In addition, the duration of the unrealized losses in the
state and municipal portfolio have all been less than twelve
months.  Management has the intent and the ability to hold the
securities until recovery and is unaware of any other circumstances which may
indicate other-than-temporary impairment.





NOTE
3 – LOANS





Loans at
year-end were as follows:





2008
                  
                  
                  2007(In
      thousands)Commercial
                  
                  $
                  95,365
                  
                  
                  $
                  88,353Real
      Estate:Residential
                  
                  
                  177,230
                  
                  
                  
                  186,831Commercial
                  
                  
                  206,973
                  
                  
                  
                  191,774Construction
                  
                  
                  73,936
                  
                  
                  
                  87,364Home
      Equity
                  
                  
                  60,539
                  
                  
                  
                  60,380Loans
      secured by deposit accounts
                  
                  
                  1,242
                  
                  
                  
                  1,322Consumer
                  
                  
                  17,296
                  
                  
                  
                  20,024Subtotal
                  
                  
                  632,581
                  
                  
                  
                  636,048Less:     Allowance
      for loan losses
                  
                  
                  (9,478
                  )
                  
                  
                  (6,316
                  )Loans,
      net
                  
                  $
                  623,103
                  
                  
                  $
                  629,732





During
2008 and 2007, substantially all of the Company’s residential and commercial
real estate loans were pledged as collateral to the Federal Home Loan Bank to
secure advances.





Activity
in the allowance for loan losses was as follows:





2008
                  
                  
                  2007
                  
                  
                  2006(In
      thousands)Beginning
      balance
                  
                  $
                  6,316
                  
                  
                  $
                  5,654
                  
                  
                  $
                  5,920Acquired
      allowance of SCSB, July 1, 2006
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  754Provision
      for loan losses
                  
                  
                  6,857
                  
                  
                  
                  1,296
                  
                  
                  
                  262Loans
      charged-off
                  
                  
                  (3,813
                  )
                  
                  
                  (801
                  )
                  
                  
                  (1,354
                  )Recoveries
                  
                  
                  118
                  
                  
                  
                  167
                  
                  
                  
                  72Ending
      balance
                  
                  $
                  9,478
                  
                  
                  $
                  6,316
                  
                  
                  $
                  5,654


























68
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006




NOTE 3 – LOANS
(Continued)





Information
about impaired loans is presented below.  There were no impaired loans
for the periods presented without an allowance allocation.





2008
                  
                  
                  2007
                  
                  
                  2006(In
      thousands)Impaired
      loans at year-end
                  
                  $
                  20,189
                  
                  
                  $
                  9,295
                  
                  
                  $
                  4,399Amount
      of the allowance for loan losses allocated
                  
                  
                  4,413
                  
                  
                  
                  1,593
                  
                  
                  
                  865Average
      of impaired loans during the year
                  
                  
                  8,107
                  
                  
                  
                  4,628
                  
                  
                  
                  4,783Interest
      income recognized and received during impairment
                  
                  
                  4
                  
                  
                  
                  75
                  
                  
                  
                  1Nonperforming
      loans at year-end were as follows.Loans
      past due over 90 days still on accrual
                  
                  $
                  -
                  
                  
                  $
                  244
                  
                  
                  $
                  -Non-accrual
      loans
                  
                  
                  20,702
                  
                  
                  
                  11,134
                  
                  
                  
                  5,566





Nonperforming
loans includes both smaller balance homogenous loans that are collectively
evaluated for impairment and individually classified impaired
loans.





Related Party Loans:
Loans to principal officers, directors, and their affiliates were as
follows.





2008(In
      thousands)Beginning
      loans
                  
                  $
                  22,655New
      loans
                  
                  
                  10,715Effect
      of changes in related parties
                  
                  
                  413Repayments
                  
                  
                  (9,976
                  )Ending
      loans
                  
                  $
                  23,807





Off-balance-sheet
commitments (including commitments to make loans, unused lines of credit, and
letters of credit) to principal officers, directors, and their affiliates as of
December 31, 2008 and 2007 were $12.6 million and $7.7 million.





Mortgage Banking
Activities: Mortgage loans serviced for others are not included in the
accompanying consolidated balance sheets.  The unpaid principal
balances of mortgage loans serviced for others were approximately $14.4 million
and $17.3 million at year-end 2008 and 2007.  Custodial escrow
balances maintained in connection with the foregoing loan servicing, and
included in non-interest bearing deposits, were approximately $79,000 and
$62,000 at year-end 2008 and 2007.  Servicing assets related to these
loans, included in other assets, were $69,000 and $147,000 at year-end 2008 and
2007.  The servicing asset valuation allowance was $69,000 and $0 at
year-end 2008 and 2007.  Amortization expense was $8,000, $8,000 and
$9,000 at year-end 2008, 2007, and 2006.  The company recorded
impairment charges of $69,000, $0, and $0 in 2008, 2007, and 2006. The fair
value for mortgage servicing rights were $69,000 and $158,000 at year-end 2008
and 2007.  Fair value at year-end 2008 was determined using a discount
rate of 12.0%, prepayment speeds ranging from 18.00% to 45.00%, depending on the
stratification of the specific right, and a default rate of
0.00%.  Fair value at year-end 2007 was determined using a discount
rate of 9.50%, prepayment speeds ranging from 8.50% to 40.00%, depending on the
stratification of the specific right, and a default rate of 0.00%.


The
weighted average amortization period is 5.4 years.  Estimated
amortization expense for each of the next five years is approximately $12,800
per year.




69
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006




NOTE
4- PREMISES AND EQUIPMENT





Year-end
premises and equipment were as follows.





2008
                
                
                2007(In
      thousands)Land
      and land improvements
                
                $
                2,766
                
                
                $
                2,629Buildings
                
                
                13,176
                
                
                
                13,225Furniture,
      fixtures and equipment
                
                
                11,085
                
                
                
                10,818Leasehold
      improvements
                
                
                1,384
                
                
                
                1,19828,411
                
                
                
                27,870Less:  Accumulated
      depreciation
                
                
                (13,283
                )
                
                
                (12,723
                )$
                15,128
                
                
                $
                15,147





Depreciation
expense was $1.5 million, $1.3 million, and $1.2 million for 2008, 2007, and
2006.





Branch
location rent expense was $672,000, $512,000 and $409,000 for 2008, 2007, and
2006, respectively.  Rent commitments under noncancelable operating
leases (in thousands) were as follows, before considering renewal options that
generally are present.








2009
                        
                        $
                        6262010
                        
                        
                        5542011
                        
                        
                        5462012
                        
                        
                        5322013
                        
                        
                        404Thereafter
                        
                        
                        1,355Total
                        
                        $
                        4,017





NOTE
5 – GOODWILL AND INTANGIBLE ASSETS





Goodwill





The
change in balance for goodwill during the year is as follows (in
thousands):








2008
                  
                  
                  2007Beginning
      of year
                  
                  $
                  15,335
                  
                  
                  $
                  15,983Acquisition
      adjustments
                  
                  
                  -
                  
                  
                  
                  (648
                  )End
      of year
                  
                  $
                  15,335
                  
                  
                  $
                  15,335








The
adjustments to goodwill in 2007 resulted from the finalization of the fair value
of assets acquired with the purchase of TBI on July 1, 2006.











70
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE 5 – GOODWILL AND INTANGIBLE
ASSETS(Continued)





Acquired
Intangible Assets





Acquired
intangible assets were as follows at year end (in thousands):





2008
                  
                  
                  2007Gross
                    Carrying
                    Amount
                  
                  
                  AccumulatedAmortization
                  
                  
                  Gross
                    Carrying
                    Amount
                  
                  
                  AccumulatedAmortizationAmortized
      intangible assets:Core
      deposit intangibles (see Note 2)
                  
                  $
                  3,069
                  
                  
                  $
                  930
                  
                  
                  $
                  3,069
                  
                  
                  $
                  581Other
      customer relationship intangibles
                  
                  
                  443
                  
                  
                  
                  90
                  
                  
                  
                  443
                  
                  
                  
                  32Total
                  
                  $
                  3,512
                  
                  
                  $
                  1,020
                  
                  
                  $
                  3,512
                  
                  
                  $
                  613








Aggregate
amortization expense was $407,000, $438,000 and $176,000 for 2008, 2007 and
2006.





Estimated
amortization expense for each of the next five years (in
thousands):





2009
                        
                        $
                        3952010
                        
                        
                        3892011
                        
                        
                        3772012
                        
                        
                        3562013
                        
                        
                        332





NOTE
6 – DEPOSITS





Time
deposits of $100,000 or more were $118.0 million and $101.0 million at year-end
2008 and 2007.   Brokered deposits were $5.9 million at year-end
2008 and 2007.





Scheduled
maturities of time deposits for the next five years (in thousands) were as
follows:





2009
                    
                    $
                    238,8672010
                    
                    
                    41,4412011
                    
                    
                    4,9652012
                    
                    
                    2,4062013
                    
                    
                    828








Deposits
from principal officers, directors and their affiliates at year-end 2008 and
2007 were approximately $28.7 million and $22.2 million.























71
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE
7 – OTHER BORROWINGS





Other
borrowings consist of retail repurchase agreements representing overnight
borrowings from deposit customers, federal funds purchased representing
overnight borrowings from other financial institutions, lines of credit with
other financial institutions and a structured repurchase
agreement.  The debt securities sold under the repurchase agreements
were under the control of the subsidiary banks during 2008 and
2007.





The
Company has available a revolving line of credit with a bank for $10.0
million.  The line of credit expires on June 30, 2009 and bears
interest at LIBOR plus 1.25% (2.97% at December 31, 2008).  Payments
are due quarterly and are interest only.  The line of credit is
collateralized by 500 shares of Your Community Bank common stock.  The
outstanding balance on the line of credit was $9.2 million and $8.6 million at
December 31, 2008 and 2007.





Information
concerning 2008 and 2007 other borrowings is summarized as follows.





2008
                    
                    
                    2007(Dollars
      in thousands)Repurchase
      agreements at year-endBalance
                    
                    $
                    60,011
                    
                    
                    $
                    54,443Weighted
      average interest rate
                    
                    
                    0.42
                    %
                    
                    
                    3.36
                    %Repurchase
      agreements during the yearAverage
      daily balance
                    
                    $
                    50,260
                    
                    
                    $
                    48,547Maximum
      month-end balance
                    
                    
                    60,011
                    
                    
                    
                    54,443Weighted
      average interest rate
                    
                    
                    1.30
                    %
                    
                    
                    4.10
                    %Federal
      funds purchased and lines of credit at year-endBalance
                    
                    $
                    9,172
                    
                    
                    $
                    8,553Weighted
      average interest rate
                    
                    
                    2.97
                    %
                    
                    
                    6.01
                    %Federal
      funds purchased and lines of credit during the yearAverage
      daily balance
                    
                    $
                    10,631
                    
                    
                    $
                    13,687Maximum
      month-end balance
                    
                    
                    28,367
                    
                    
                    
                    32,139Weighted
      average interest rate
                    
                    
                    4.22
                    %
                    
                    
                    5.78
                    %Structured
      repurchase agreement at year-endBalance
                    
                    $
                    9,800
                    
                    
                    $
                    9,800Weighted
      average interest rate
                    
                    
                    4.90
                    %
                    
                    
                    2.79
                    %Structured
      repurchase agreement during the yearAverage
      daily balance
                    
                    $
                    9,800
                    
                    
                    $
                    1,128Maximum
      month-end balance
                    
                    
                    9,800
                    
                    
                    
                    9,800Weighted
      average interest rate
                    
                    
                    3.05
                    %
                    
                    
                    2.72
                    %


























72
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE
8 - FEDERAL HOME LOAN BANK ADVANCES





At
year-end, advances from the Federal Home Loan Bank (FHLB) were as
follows.


2008
                                                        
                                                        
                                                        2007Weighted
      Average Rate
                                                        
                                                        
                                                        Amount
                                                        
                                                        
                                                        Weighted
      Average Rate
                                                        
                                                        
                                                        Amount(Dollars
      in thousands)Fixed
      rate
                                                        
                                                        
                                                        4.90
                                                        %
                                                        
                                                        $
                                                        111,943
                                                        
                                                        
                                                        
                                                        5.63
                                                        %
                                                        
                                                        $
                                                        91,376
   The
advances were collateralized by $320.1 million and $335.6 million of first
mortgage and commercial real estate loans under a blanket lien arrangement and
certain available for sale securities at year-end 2008 and
2007.  Based on this collateral and the Company’s holdings of FHLB
stock, the Company is eligible to borrow an additional $46.7 million at year-end
2008.







The
contractual maturities of advances outstanding as of December 31, 2008 are as
follows:


(In
      thousands)2009
                    
                    $
                    31,9912010
                    
                    
                    64,9522011
                    
                    
                    10,0002012
                    
                    
                    -2013
                    
                    
                    5,000$
                    111,943








The fixed
rate advances include of $67.0 million in convertible advances.  The
FHLB has the quarterly right to require the Company to choose either conversion
of the fixed rate to a variable rate tied to the three month LIBOR index or
prepayment of the advance without penalty.  There is a substantial
penalty if the Company prepays the advances before FHLB exercises its
right.









































73
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE
9 - SUBORDINATED DEBENTURES





On June 15, 2006, a trust  formed by
the  Company,  Community Bank Shares (IN) Statutory Trust II
(Trust II), issued  $10.0 million of floating rate trust preferred
securities as part of a pooled offering of such securities.  On June
17, 2004, a trust formed by the Company, Community Bank Shares (IN) Statutory
Trust I (Trust I), issued $7.0 million of floating  rate trust
preferred securities as part of a pooled offering of such
securities.  The Company issued subordinated debentures to Trusts I
and II in exchange for the proceeds of each offering; the debentures and related
debt issuance costs represent the sole assets of Trusts I and
II.  Distributions on the trust preferred securities are payable
quarterly in arrears at the annual rate (adjusted quarterly) of three-month
LIBOR plus 1.70% (3.70% as of the last adjustment) for Trust II and three-month
LIBOR plus 2.65% (4.52% as of the last adjustment) for Trust I and are included
in interest  expense.





The
maturity dates of the subordinated debentures are June 15, 2036 for Trust II and
June 17, 2034 for Trust I. The subordinated debentures may be redeemed by the
Company, in whole or in part, at any distribution payment date on or after the
distribution payment date in June 2011 for Trust II and June 2009 for Trust I,
at the redemption price. The subordinated debentures have variable rates,
adjusted quarterly, which are identical to the trust preferred
securities.  In addition, the subordinated debentures are redeemable
in whole or in part from time to time, upon the occurrence of specific events
defined within the trust debenture.  The Company has the option to
defer interest payments on the subordinated debt from time to time for a period
not to exceed five consecutive years.  Should interest payments be
deferred, the Company is restricted from paying dividends until all deferred
payments have been made.







Subordinated
debentures are considered as Tier I capital for the Company under current
regulatory guidelines.












































































74
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE
10 – BENEFIT PLANS





Defined Benefit
Plans:  The Company sponsors a defined benefit pension
plan.  The benefits are based on years of service and the employees’
highest average of total compensation for five consecutive years of
employment.  In 1997, the plan was amended such that there can be no
new participants or increases in benefits to the participants.  The
Company uses December 31st as its
measurement date for its pension plan.





A
reconciliation of the projected benefit obligation and the value of plan assets
follow.




2008
                    
                    
                    2007(In
      thousands)Change
      in projected benefit obligationBalance,
      beginning of year
                    
                    $
                    991
                    
                    
                    $
                    933Interest
      cost
                    
                    
                    56
                    
                    
                    
                    53Actuarial
      (gain) loss
                    
                    
                    (47
                    )
                    
                    
                    52Benefits
      paid to participants
                    
                    
                    (33
                    )
                    
                    
                    (47
                    )Ending
      benefit obligation
                    
                    
                    967
                    
                    
                    
                    991Change
      in plan assetsFair
      value, beginning of year
                    
                    
                    702
                    
                    
                    
                    659Actual
      return on plan assets
                    
                    
                    (211
                    )
                    
                    
                    18Employer
      contributions
                    
                    
                    128
                    
                    
                    
                    72Benefits
      paid to participants
                    
                    
                    (33
                    )
                    
                    
                    (47
                    )Fair
      value, end of year
                    
                    
                    586
                    
                    
                    
                    702Funded
      status
                    
                    $
                    (381
                    )
                    
                    $
                    (289
                    )







Amounts
recognized in accumulated other comprehensive loss consisted of a net actuarial
loss of $584,000 and $372,000 at year-end 2008 and 2007.  The
accumulated benefit obligation was $967,000 and $991,000 at year-end 2008 and
2007.  The funded status of the plan was a liability as of the years
ended 2008 and 2007 is reported in other liabilities in the Company’s
consolidated financial statements.





Components of Net Periodic
Benefit Cost and Other Amounts Recognized in Other Comprehensive
Loss





2008
                  
                  
                  2007
                  
                  
                  2006(Dollars
      in thousands)Interest
      cost
                  
                  $
                  56
                  
                  
                  $
                  53
                  
                  
                  $
                  52Expected
      return on plan assets
                  
                  
                  (56
                  )
                  
                  
                  (53
                  )
                  
                  
                  (49
                  )Amortization
      of unrecognized loss
                  
                  
                  8
                  
                  
                  
                  27
                  
                  
                  
                  43Net
      periodic benefit cost
                  
                  
                  8
                  
                  
                  
                  27
                  
                  
                  
                  46Net
      loss
                  
                  
                  212
                  
                  
                  
                  60
                  
                  
                  
                  -Total
      recognized in other comprehensive loss
                  
                  
                  212
                  
                  
                  
                  60
                  
                  
                  
                  -Total
      recognized in net periodic benefit cost and othercomprehensive
      loss
                  
                  $
                  220
                  
                  
                  $
                  87
                  
                  
                  $
                  46




75
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006




NOTE 10 – BENEFIT PLANS
(Continued)





The
estimated net loss for the defined benefit pension plan that will be amortized
from accumulated other comprehensive loss into net periodic benefit cost over
the next fiscal year is $16,000.





Assumptions





2008
                  
                  
                  2007
                  
                  
                  2006Discount
      rate on benefit obligation
                  
                  
                  6.00
                  %
                  
                  
                  5.75
                  %
                  
                  
                  5.75
                  %Rate
      of expected return on plan assets
                  
                  
                  8.00
                  %
                  
                  
                  8.00
                  %
                  
                  
                  8.00
                  %Discount
      rate for periodic benefit costs
                  
                  
                  5.75
                  %
                  
                  
                  5.75
                  %
                  
                  
                  5.50
                  %





Plan
Assets:  The Company’s target allocation for 2009, pension plan
asset allocation at year-end 2008 and 2007, and expected long-term rate of
return by asset category are as follows:








Target
                    Allocation
                  
                  
                  Percentage
      of Plan
                    Assets
      at Year-end
                  
                  
                  Weighted-Average
                    Expected
      Long-Term2009
                  
                  
                  2008
                  
                  
                  2007
                  
                  
                  Rate of ReturnAsset
      CategoryMutual
      funds
                  
                  
                  85
                  %
                  
                  
                  98
                  %
                  
                  
                  99
                  %
                  
                  
                  9.0
                  %Money
      market
                  
                  
                  15
                  
                  
                  
                  2
                  
                  
                  
                  1
                  
                  
                  
                  4.0Total
                  
                  
                  100
                  %
                  
                  
                  100
                  %
                  
                  
                  100
                  %
                  
                  
                  8.0
                  %








The
expected long-term return is based on a periodic review and modeling of the
plan’s asset allocation and liability structure over a long-term
horizon.  Expectations of returns on each asset class are the most
important of the assumptions used in the review and modeling and are based on
reviews of historical data.  The expected long-term rate of return on
assets was selected from within the reasonable  range of rates
determined by (a) historical real returns, net of inflation, for the asset
classes covered by the investment policy, and (b) projections of inflation over
the long-term period during which benefit are payable to plan
participants.





Estimated Future
Payments:   The following benefit payments, which reflect
expected future service, are expected (in thousands):






Pension
                                                        Benefits2009
                                                      
                                                      $
                                                      322010
                                                      
                                                      
                                                      322011
                                                      
                                                      
                                                      322012
                                                      
                                                      
                                                      322013
                                                      
                                                      
                                                      32Years
      2014-2018
                                                      
                                                      
                                                      260


The
Company expects to contribute approximately $44,000 to its pension plan in
2009.





Your
Community Bank is a participant in the Financial Institutions Retirement Fund, a
multi-employer defined benefit pension plan covering two of its
employees.  Employees are fully vested at the completion of five years
of participation in the plan.  No contributions were required during
the three-year period ended December 31, 2008.  There have been no new
enrollments since 1998.






76
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006




NOTE 10 – BENEFIT PLANS(Continued)





Defined Benefit Plans -
SCSB:





The
Company acquired a defined benefit retirement plan upon the purchase of
SCSB.  Per the merger agreement, the plan was
curtailed.  The Company settled this plan in the fourth quarter of
2007 which resulted in a gain of $49,000.





Employee Stock Ownership
Plan:  In the fourth quarter of 2007, the Company terminated
the ESOP and distributed all the shares held in the ESOP trust to
participants.  Contributions to the ESOP and expense were $0 for 2008,
2007 and 2006.





Deferred Compensation
Arrangements:  The Company has entered into deferred
compensation arrangements with certain directors and officers.  The
liability for such arrangements is fully accrued during the service period, with
benefits paid monthly upon retirement until death, or date specified by the
agreement.  The liability was $295,000 and $360,000 at December 31,
2008 and 2007, respectively, and was included in other liabilities in the
Company’s consolidated financial statements.  Expense related to these
arrangements for 2008, 2007 and 2006 was $(11,000), $15,000 and
$17,000.





Defined Contribution
Plans:  The 401(k) benefit plan matches employee contributions
equal to 100% of the first 3% plus 50% of the next 2% of the compensation
contributed.  Expense for 2008, 2007 and 2006 was $274,000, $213,000
and $206,000.








NOTE
11 – STOCK-BASED COMPENSATION PLANS





The
Company has three share based compensation plans as described
below.  Total compensation cost that has been charged against income
for those plans was $325,000, $122,000, and $332,000 for 2008, 2007, and
2006.  The total income tax benefit was $68,000, $1,000, and
$82,000.





Stock
Options:  The Company’s stock option plan provides for the
granting of both incentive and nonqualified stock options for up to 400,000
shares of common stock at exercise prices not less than the fair market value of
the common stock on the date of grant and expiration dates of up to ten
years.  Terms of the options are determined by the Board of Directors
at the date of grant and generally vest over periods of three to four
years.  Non-employee directors are eligible to receive only
nonqualified stock options.  As of December 31, 2008, the plan allows
for additional option grants of up to 217,550 shares.





The fair
value of each option award is estimated on the date of grant using the
Black-Scholes model that uses the assumptions noted in the table
below.  Expected volatilities are based on historical volatilities of
the Company’s common stock.  The Company uses historical data to
estimate option exercise and post-vesting termination behavior.  The
expected term of options granted is based on historical data and represents the
period of time that options granted are expected to be outstanding, which takes
into account that the options are not transferable.  The risk-free
interest rate for the expected term of the option is based on the U.S. Treasury
yield curve in effect at the time of the grant.














77
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE 11 – STOCK-BASED COMPENSATION
PLANS (Continued)





The fair
value of options granted was determined using the following weighted-average
assumptions as of grant date.  The Company did not grant options
during 2008.





2007
                    
                    
                    2006Risk-free
      interest rate
                    
                    
                    5.10
                    %
                    
                    
                    5.07
                    %Expected
      term
                    
                    5.7 years
                    
                    
                    5.7
      yearsExpected
      stock price volatility
                    
                    
                    15.38
                    %
                    
                    
                    16.09
                    %Dividend
      yield
                    
                    
                    3.24
                    %
                    
                    
                    2.91
                    %





A summary
of the activity in the stock option plan for 2008 follows:





Shares
                
                
                Weighted
                  Average
                  Exercise
                  Price
                
                
                Weighted
                  Average
                  Remaining
                  Contractual
                  Term
                
                
                Aggregate
                  Intrinsic
                  Value(In
      thousands)
                
                
                (In
      thousands)Outstanding
      at beginning of year
                
                
                301
                
                
                $
                20.40Granted
                
                
                -
                
                
                
                -Exercised
                
                
                -
                
                
                
                -Forfeited
                
                
                (5
                )
                
                
                21.98Expired
                
                
                (33
                )
                
                
                18.88Outstanding
      at end of year
                
                
                263
                
                
                $
                20.56
                
                
                
                7.1
                
                
                $
                -Vested
      and expected to vest
                
                
                263
                
                
                $
                20.56
                
                
                
                7.1
                
                
                $
                -Exercisable
      at end of year
                
                
                150
                
                
                $
                19.35
                
                
                
                4.5
                
                
                $
                -





Information
related to the stock option plan during each year follows (in thousands, except
for weighted fair value of options granted):





2008
                      
                      
                      2007
                      
                      
                      2006Intrinsic
      value of options exercised
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      9Cash
      received from option exercises
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      15Tax
      benefit realized from option exercises
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      80Weighted
      average fair value of options granted
                      
                      
                      -
                      
                      
                      
                      2.76
                      
                      
                      
                      3.61





As of
December 31, 2008, there was $116,000 of total unrecognized compensation cost
related to nonvested stock options granted under the Plan.  The cost
is expected to be recognized over a weighted-average period of 1.18
years.





Performance Units
Awards:  The Company may grant performance unit awards to
employees for up to 275,000 shares of common stock.  The level of
performance shares eventually distributed is contingent upon the achievement of
specific performance criteria within a specified award period set at the grant
date.  The Company estimates the progress toward achieving these
objectives when estimating the number of awards expected to vest and
correspondingly, periodic compensation expense.














78
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006




NOTE 11 – STOCK-BASED COMPENSATION
PLANS (Continued)





The
compensation cost attributable to these restricted performance units awards is
based on both the fair market value of the shares at the grant date and the
Company’s stock price at the end of a reporting cycle.  Thirty-five
percent of the total award will be paid in cash and is therefore classified as a
liability, with total compensation cost changing as the Company’s stock price
changes.  The remaining sixty-five percent is classified as an equity
award; total compensation cost is based on the fair market value of sixty-five
percent of the total award on the date of grant.  The compensation
expense is recognized over the specified performance period.





A
summary of changes in the Company’s nonvested units for the year
follows:





Nonvested
      Units
                
                Units
                
                
                Weighted-Average
                  Grant-Date
                  Fair Value(In
      thousands)Nonvested
      at January 1, 2008
                
                
                29
                
                
                $
                22.45Granted
                
                
                23
                
                
                
                18.68Vested
                
                
                (29
                )
                
                
                22.45Forfeited
                
                
                -
                
                
                
                -Nonvested
      at December 31, 2008
                
                
                23
                
                
                $
                18.68








As of
December 31, 2008, there was $70,000 of total unrecognized compensation cost
related to nonvested units granted under the Plan.  The cost is
expected to be recognized over a weighted-average period of 1.0
years.  The total fair value of units vested during the years ended
December 31, 2008, 2007 and 2006 was $335,000, $0 and $259,000.  There
were no modifications or cash paid to settle performance unit awards during the
three year period ending December 31, 2008.





Restricted Share
Awards:  The Company may grant restricted share awards to
employees for up to 400,000 shares of common stock.  Compensation
expense is recognized over the vesting period of the awards based on the fair
value of the stock at issue date.  The fair value of the stock was
determined using the market value of the Company’s stock on the grant
date.  The restricted shares fully vest on the third anniversary of
the grant date.





A
summary of changes in the Company’s nonvested shares for the year
follows:





Nonvested
      Shares
                
                Shares
                
                
                Weighted-Average
                  Grant-Date
                  Fair Value(In
      thousands)Nonvested
      at January 1, 2008
                
                
                -
                
                
                $
                -Granted
                
                
                20
                
                
                
                18.72Vested
                
                
                -
                
                
                
                -Forfeited
                
                
                -
                
                
                
                -Nonvested
      at December 31, 2008
                
                
                20
                
                
                $
                18.72











79
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE 11 – STOCK-BASED COMPENSATION
PLANS (Continued)





As of
December 31, 2008, there was $259,000 of total unrecognized compensation cost
related to nonvested shares granted under the Plan.  The cost is
expected to be recognized over a weighted-average period of 2.1
years.  There were no shares that vested during the years ended
December 31, 2008, 2007 and 2006.  There were no modifications or cash
paid to settle restricted share awards during the three year period ended
December 31, 2008.





NOTE
12 - INCOME TAXES





Income
tax expense (benefit) was as follows.








2008
                      
                      
                      2007
                      
                      
                      2006(In
      thousands)Current
                      
                      $
                      383
                      
                      
                      $
                      1,221
                      
                      
                      $
                      1,177Deferred
                      
                      
                      (1,458
                      )
                      
                      
                      (393
                      )
                      
                      
                      81Change
      in valuation allowance
                      
                      
                      384
                      
                      
                      
                      77
                      
                      
                      
                      85Total
                      
                      $
                      (691
                      )
                      
                      $
                      905
                      
                      
                      $
                      1,343





Effective
tax rates differ from federal statutory rates applied to financial statement
income due to the following.




2008
                  
                  
                  2007
                  
                  
                  2006(Dollars
      in thousands)Federal
      statutory rate timesfinancial
      statement income
                  
                  $
                  44
                  
                  
                  
                  34.0
                  %
                  
                  $
                  1,499
                  
                  
                  
                  34.0
                  %
                  
                  $
                  1,854
                  
                  
                  
                  34.0
                  %Effect
      of:Tax-exempt
      income
                  
                  
                  (381
                  )
                  
                  
                  (292.6
                  )
                  
                  
                  (253
                  )
                  
                  
                  (5.7
                  )
                  
                  
                  (222
                  )
                  
                  
                  (4.1
                  )State
      taxes, net of federal benefit
                  
                  
                  (384
                  )
                  
                  
                  (294.7
                  )
                  
                  
                  (77
                  )
                  
                  
                  (1.7
                  )
                  
                  
                  (85
                  )
                  
                  
                  (1.6
                  )Change
      in valuation allowance
                  
                  
                  384
                  
                  
                  
                  294.7
                  
                  
                  
                  77
                  
                  
                  
                  1.7
                  
                  
                  
                  85
                  
                  
                  
                  1.6Nontaxable
      earnings on company ownedinsurance
      policies
                  
                  
                  (250
                  )
                  
                  
                  (191.5
                  )
                  
                  
                  (231
                  )
                  
                  
                  (5.2
                  )
                  
                  
                  (195
                  )
                  
                  
                  (3.6
                  )New markets tax credit
                  
                  
                  (180
                  )
                  
                  
                  (138.1
                  )
                  
                  
                  (180
                  )
                  
                  
                  (4.1
                  )
                  
                  
                  (150
                  )
                  
                  
                  (2.8
                  )Incentive stock options expense
                  
                  
                  43
                  
                  
                  
                  32.8
                  
                  
                  
                  40
                  
                  
                  
                  0.9
                  
                  
                  
                  31
                  
                  
                  
                  0.6Other, net
                  
                  
                  33
                  
                  
                  
                  25.3
                  
                  
                  
                  30
                  
                  
                  
                  0.6
                  
                  
                  
                  25
                  
                  
                  
                  0.5Total
                  
                  $
                  (691
                  )
                  
                  
                  (530.1
                  )%
                  
                  $
                  905
                  
                  
                  
                  20.5
                  %
                  
                  $
                  1,343
                  
                  
                  
                  24.6
                  %






































80
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE 12 - INCOME TAXES
(Continued)





Year-end
deferred tax assets and liabilities were due to the following.





2008
                    
                    
                    2007(In
      thousands)Deferred
      tax assets:Allowance
      for loan losses
                    
                    $
                    3,222
                    
                    
                    $
                    2,528Employee
      benefit plans
                    
                    
                    100
                    
                    
                    
                    229Minimum
      pension liability
                    
                    
                    198
                    
                    
                    
                    126Net
      unrealized loss on securities available for sale
                    
                    
                    126
                    
                    
                    
                    -Net
      unrealized depreciation on interest rate swap
                    
                    
                    -
                    
                    
                    
                    80Net
      operating loss carryforward
                    
                    
                    806
                    
                    
                    
                    422Other
                    
                    
                    142
                    
                    
                    
                    464,594
                    
                    
                    
                    3,431Deferred
      tax liabilities:Premises
      and equipment
                    
                    
                    (407
                    )
                    
                    
                    (489
                    )FHLB
      stock
                    
                    
                    (308
                    )
                    
                    
                    (362
                    )Deferred
      loan fees and costs
                    
                    
                    (254
                    )
                    
                    
                    (169
                    )Mortgage
      servicing rights
                    
                    
                    (23
                    )
                    
                    
                    (59
                    )Net
      unrealized gain on securities available for sale
                    
                    
                    -
                    
                    
                    
                    (7
                    )Fair
      value adjustments from acquisitions
                    
                    
                    (238
                    )
                    
                    
                    (266
                    )Intangible
      assets
                    
                    
                    (847
                    )
                    
                    
                    (1,159
                    )Prepaid
      pension expense
                    
                    
                    -
                    
                    
                    
                    (32
                    )Prepaid
      expenses
                    
                    
                    (102
                    )
                    
                    
                    (173
                    )Other
                    
                    
                    (143
                    )
                    
                    
                    (106
                    )(2,322
                    )
                    
                    
                    (2,822
                    )Valuation
      allowance on net deferred tax assets
                    
                    
                    (806
                    )
                    
                    
                    (422
                    )Net
      deferred tax asset
                    
                    $
                    1,466
                    
                    
                    $
                    187





The
Company incurred net operating losses for state income taxes during years 2002
through 2008 which will be carried forward and applied to future state taxable
income.  Due to the uncertainty of the Company’s ability to use this
benefit, a valuation allowance has been recorded.  The cumulative
state net operating loss is $7.1 million and can be carried forward for 15 years
with expiration beginning in 2017.





Retained
earnings of Your Community Bank includes approximately $3.7 million for which no
deferred income tax liability has been recognized.  This amount
represents an allocation of income to bad debt deductions as of December 31,
1987 for tax purposes only.  Reduction of amounts so allocated for
purposes other than tax bad debt losses including redemption of bank stock or
excess dividends, or loss of “bank” status would create income for tax purposes
only, which would be subject to the then-current corporate income tax
rate.  The unrecorded deferred income tax liability on the above
amount for Your Community Bank at December 31, 2008 was approximately $1.3
million.




















81
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE 12- INCOME TAXES
(Continued)





Unrecognized Tax
Benefits





A
reconciliation of the beginning and ending amount of unrecognized tax benefits
is as follows:








2008
                
                
                2007(In
      thousands)Balance
      at January 1
                
                $
                55
                
                
                $
                51Additions
      based on tax positions related to the current year
                
                
                -
                
                
                
                24Reductions
      due to statute of limitations
                
                
                -
                
                
                
                (20
                )Reductions
      for tax positions of prior years
                
                
                (55
                )
                
                
                -Balance
      at December 31
                
                $
                -
                
                
                $
                55





As of
December 31, 2007, the Company’s 2004 and 2005 federal tax returns were being
audited by the Internal Revenue Service.  In the first quarter of
2008,  the Company received notification the Internal Revenue Service
had completed their audits and had determined adjustments were not required for
tax positions taken in those returns.  Accordingly, the Company
reduced its reserve for unrecognized tax benefits in 2008 by
$55,000.





The total
amount of interest and penalties recorded in the income statement for the years
ended December 31, 2008 and 2007 were $0 and $(3,000), and the amount accrued
for interest and penalties at December 31, 2008 and 2007 were $0 and
$17,000.





The
Company and its subsidiaries are subject to U.S. federal income tax as well as
income tax of the states of Indiana and Kentucky. The Company is no longer
subject to examination by taxing authorities for years before 2005.





NOTE
13 - CAPITAL REQUIREMENTS AND RESTRICTIONS ON
RETAINED EARNINGS





Banks and
bank holding companies are subject to regulatory capital requirements
administered by federal banking agencies.  Capital adequacy guidelines
and, additionally for banks, prompt corrective action regulations involve
quantitative measures of assets, liabilities, and certain off-balance-sheet
items calculated under regulatory accounting practices.  Capital
amounts and classifications are also subject to qualitative judgments by
regulators.  Failure to meet capital requirements can initiate
regulatory action.





Prompt
corrective action regulations provide five classifications:  well
capitalized, adequately capitalized, undercapitalized, significantly
undercapitalized, and critically undercapitalized, although these terms are not
used to represent overall financial condition.  If adequately
capitalized, regulatory approval is required to accept brokered
deposits.  If undercapitalized, capital distributions are limited, as
is asset growth and expansion, and capital restoration plans are
required.  As of December 31, 2008 and 2007, the most recent
regulatory notifications categorized YCB and SCSB as well capitalized under the
regulatory framework for prompt corrective action.  There are no
considerations or events since December 31, 2008 that management believes have
changed the institution’s classification as well capitalized.







82
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006




NOTE 13 - CAPITAL REQUIREMENTS AND
RESTRICTIONS ON RETAINED EARNINGS(Continued)





YCB
currently has a regulatory agreement with the FDIC that requires YCB to maintain
a Tier 1 capital ratio of 8%.  YCB is currently in compliance with the
Tier 1 capital requirement.





Actual
and required capital amounts and ratios are presented below at
year-end.





Actual
                
                
                For
      Capital
                  Adequacy Purposes
                
                
                To
      Be Well
                  Capitalized
      Under
                  Prompt
      Corrective
                  Action ProvisionsAmount
                
                
                Ratio
                
                
                Amount
                
                
                Ratio
                
                
                Amount
                
                
                Ratio2008
                
                (Dollars
      in millions)Total
      Capital (to Risk Weighted  Assets):Consolidated
                
                $
                70.7
                
                
                
                10.7
                %
                
                $
                52.7
                
                
                
                8.0
                %
                
                
                N/A
                
                
                
                N/AYour
      Community Bank
                
                
                65.5
                
                
                
                11.5
                
                
                
                45.4
                
                
                
                8.0
                
                
                
                56.8
                
                
                
                10.0
                %Scott
      County State Bank
                
                
                13.4
                
                
                
                14.1
                
                
                
                7.6
                
                
                
                8.0
                
                
                
                9.5
                
                
                
                10.0Tier
      I Capital (to Risk Weighted Assets):Consolidated
                
                $
                62.4
                
                
                
                9.5
                %
                
                $
                26.3
                
                
                
                4.0
                %
                
                
                N/A
                
                
                
                N/AYour
      Community Bank
                
                
                58.3
                
                
                
                10.3
                
                
                
                22.7
                
                
                
                4.0
                
                
                
                34.1
                
                
                
                6.0
                %Scott
      County State Bank
                
                
                12.7
                
                
                
                13.3
                
                
                
                3.8
                
                
                
                4.0
                
                
                
                5.7
                
                
                
                6.0Tier
      I Capital (to Average Assets):Consolidated
                
                $
                62.4
                
                
                
                7.6
                %
                
                $
                33.1
                
                
                
                4.0
                %
                
                
                N/A
                
                
                
                N/AYour
      Community Bank
                
                
                58.3
                
                
                
                8.2
                
                
                
                28.3
                
                
                
                4.0
                
                
                
                35.4
                
                
                
                5.0
                %Scott
      County State Bank
                
                
                12.7
                
                
                
                9.4
                
                
                
                5.4
                
                
                
                4.0
                
                
                
                6.7
                
                
                
                5.02007Total
      Capital (to Risk Weighted  Assets):Consolidated
                
                $
                69.8
                
                
                
                10.9
                %
                
                $
                51.1
                
                
                
                8.0
                %
                
                
                N/A
                
                
                
                N/AYour
      Community Bank
                
                
                62.6
                
                
                
                11.2
                
                
                
                44.6
                
                
                
                8.0
                
                
                
                55.8
                
                
                
                10.0
                %Scott
      County State Bank
                
                
                13.7
                
                
                
                15.9
                
                
                
                6.9
                
                
                
                8.0
                
                
                
                8.6
                
                
                
                10.0Tier
      I Capital (to Risk Weighted Assets):Consolidated
                
                $
                63.5
                
                
                
                9.9
                %
                
                $
                25.6
                
                
                
                4.0
                %
                
                
                N/A
                
                
                
                N/AYour
      Community Bank
                
                
                56.9
                
                
                
                10.2
                
                
                
                22.3
                
                
                
                4.0
                
                
                
                33.5
                
                
                
                6.0
                %Scott
      County State Bank
                
                
                13.1
                
                
                
                15.2
                
                
                
                3.4
                
                
                
                4.0
                
                
                
                5.2
                
                
                
                6.0Tier
      I Capital (to Average Assets):Consolidated
                
                $
                63.5
                
                
                
                8.0
                %
                
                $
                31.9
                
                
                
                4.0
                %
                
                
                N/A
                
                
                
                N/AYour
      Community Bank
                
                
                56.9
                
                
                
                8.6
                
                
                
                26.5
                
                
                
                4.0
                
                
                
                33.1
                
                
                
                5.0
                %Scott
      County State Bank
                
                
                13.1
                
                
                
                9.5
                
                
                
                5.5
                
                
                
                4.0
                
                
                
                6.9
                
                
                
                5.0










83
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006




NOTE 13 - CAPITAL REQUIREMENTS AND
RESTRICTIONS ON RETAINED EARNINGS(Continued)





Dividend
Restrictions:  The Company’s principal source of funds for
dividend payments is dividends received from the Banks.  Banking
regulations limit the amount of dividends that may be paid without prior
approval of regulatory agencies.  Under these regulations, the amount
of dividends that may be paid in any calendar year is limited to the current
year’s retained net profits, combined with the retained net profits of the
preceding two years, subject to the capital requirements described
above.  During 2009, the YCB and SCSB could, without prior approval,
declare dividends of approximately $799,000 and $0 plus any 2009 net profits
retained to the date of the dividend declaration, respectively.





NOTE
14 – INTEREST RATE SWAPS





On August
30, 2002, the Company entered into a $25,000,000 notional amount interest rate
swap arrangement to exchange variable payments of interest tied to Prime for
receipt of fixed rate payments of 6.51% which matured on August 30,
2007.  An additional $25,000,000 notional amount interest rate swap
was entered into on June 19, 2003 to exchange variable payments of interest tied
to Prime for receipt of fixed rate payments of 5.22% which matured on June 19,
2008.  The variable rate of the swaps reset daily, with net interest
being settled monthly.  The notional amount of the swaps did not
represent amounts exchanged by the parties.  The amounts exchanged
were determined by reference to the notional amount and other terms of the
swaps.





Prior to
December 31, 2007, these interest rate swap agreement were reported, and had
been since their inception, as cash flow hedges as the Company believed the
critical terms of the swap agreements matched the critical terms of the variable
rate loans and concluded that interest rate swap agreements were effective cash
flow hedges.  As of December 31, 2007, the Company determined that
accounting for these agreements as cash flows hedges was in error because a
critical term did not match.  The Company did not designate the swap
agreements to pools of variable rate loans with like spreads to prime rate, such
as prime plus .25%, prime plus .50%, etc., but did so only in
total.  Therefore, fluctuations in the fair value of the interest rate
swaps should have been recorded in other non-interest income instead of in other
comprehensive loss.  As of December 31, 2007, the remaining interest
rate swap had a fair value of $234,000, which amount was reversed out of other
comprehensive loss and reported in other non-interest income.  The
Company reported a gain of $234,000 on the maturation of the swap for the
year-ended December 31, 2008.  During the 12 months ended December 31,
2008, 2007 and 2006, respectively, the Company recognized expense of $54,000,
$1,014,000 and $1,061,000, respectively.  The fair value of the swap
was a liability of $234,000 as of year–end 2007 and was reported in other
liabilities in the Company’s consolidated financial statements.





NOTE
15 - OFF-BALANCE-SHEET ACTIVITIES





Some
financial instruments, such as commitments to make loans for the Company’s
portfolio, credit lines and letters of credit, are issued to meet
customer-financing needs.  These are agreements to provide credit or
to support the credit of others, as long as conditions established in the
contract are met, and usually have expiration dates.  Commitments may
expire without being used.  Off-balance-sheet risk to credit loss
exists up to the face amount of these instruments, although material losses are
not anticipated.  The same credit policies are used to make such
commitments as are used for loans, including obtaining collateral at exercise of
the commitment.








84
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE 15 - OFF-BALANCE-SHEET
ACTIVITIES(Continued)





The
contractual amount of financial instruments with off-balance-sheet risk was as
follows at year-end.





2008
                      
                      
                      2007Fixed
                        Rate
                      
                      
                      Variable
                        Rate
                      
                      
                      Fixed
                        Rate
                      
                      
                      Variable
                        Rate(In
      thousands)Commitments
      to make loans
                      
                      $
                      1,734
                      
                      
                      $
                      350
                      
                      
                      $
                      858
                      
                      
                      $
                      13,731Unused
      lines of credit
                      
                      
                      2,493
                      
                      
                      
                      119,803
                      
                      
                      
                      8,043
                      
                      
                      
                      127,959Letters
      of credit
                      
                      
                      -
                      
                      
                      
                      5,737
                      
                      
                      
                      -
                      
                      
                      
                      6,914








Commitments
to make loans are generally made for periods of 30 days or less and are at
market rates.  The fixed rate loan commitments have interest rates
ranging from approximately 4.88% to 8.88% and maturities ranging from 3 years to
15 years.





NOTE
16 - FAIR VALUE





FASB
Statement No. 157 establishes a fair value hierarchy which requires an entity to
maximize the use of observable inputs and minimize the use of unobservable
inputs when measuring fair value.  The standard describes three levels
of inputs that may be used to measure fair value:





Level
1:  Quoted prices (unadjusted) for identical assets or
liabilities in active markets that the entity has the ability to access as of
the measurement date.





Level
2:  Significant other observable inputs other than Level 1
prices, such as quoted prices for similar assets or liabilities, quoted prices
in markets that are not active, and other inputs that are observable or can be
corroborated by observable market data.





Level
3:  Significant unobservable inputs that reflect a company’s
own assumptions about the assumptions that market participants would use in
pricing an asset or liability.





The
Company used the following methods and significant assumptions to estimate fair
value.





Securities:  The
fair values of securities available for sale are determined by obtaining quoted
prices on nationally recognized securities exchanges (Level 1 inputs) or matrix
pricing, which is a mathematical technique used widely in the industry to value
debt securities without relying exclusively on quoted prices for the specific
securities but rather by relying on the securities’ relationship to other
benchmark quoted securities (Level 2 inputs). In instances where broker quotes
are used, these quotes are obtained from market makers or broker-dealers
recognized to be market participants. These valuation methods are classified as
Level 2 in the fair value hierarchy.


























85
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006




NOTE 16 - FAIR VALUE(Continued)





Collateralized debt obligations which
are issued by financial institutions and insurance companies were historically
priced using Level 2 inputs, the decline in the level of observable inputs and
market activity in this class of investments by the measurement date has been
significant and resulted in unreliable external pricing.  Broker
pricing and bid/ask spreads, when available, vary widely.  The once
active market has become comparatively inactive.  As such, these
investments are now priced using Level 3 inputs.  The fair values of
our collateralized debt obligations are determined by capital market traders of
our bond accountant using a base discount margin driven by current market
fundamentals adjusted for characteristics unique to each security and the
security’s discounted projected cash flows.





Impaired
Loans:  The fair value of impaired loans with specific
allocations of the allowance for loan losses is generally based on recent real
estate appraisals. These appraisals may utilize a single valuation approach or a
combination of approaches including comparable sales and the income approach.
Adjustments are routinely made in the appraisal process by the appraisers to
adjust for differences between the comparable sales and income data available.
Such adjustments are typically significant and result in a Level 3
classification of the inputs for determining fair value.





Servicing
Rights:  The fair value of servicing rights is based on a
valuation model that calculates the present value of estimated net servicing
income.  The valuation model incorporates assumptions that market
participants would use in estimating future net servicing income.  The
Company is able to compare the valuation model inputs and results to widely
available published industry data for reasonableness (Level 2
inputs).





Assets
measured at fair value on a recurring basis are summarized below:




Fair
      Value Measurements at December 31, 2008, UsingAssets
      at Fair Value at December 31, 2008
                                  
                                  
                                  Quoted
      Prices in Active Markets for Identical Assets (Level 1)
                                  
                                  
                                  Significant
      Other Observable Inputs (Level 2)
                                  
                                  
                                  Significant
      Unobservable Inputs (Level 3)(in
      thousands)Assets:Available
      for sale securities
                                  
                                  $
                                  121,659
                                  
                                  
                                  $
                                  —
                                  
                                  
                                  $
                                  118,374
                                  
                                  
                                  $
                                  3,285









































86
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006




NOTE 16 - FAIR VALUE(Continued)





The
rollforward of activity for the Company’s significant unobservable inputs (Level
3) is as follows:




Twelve
      Months Ended December 31, 2008(in
      thousands)Balance,
      January 1, 2008
                              
                              $
                              —Transfer
      into level 3, April 1, 2009
                              
                              
                              5,189Net
      unrealized loss
                              
                              
                              (1,756
                              )Principal
      paydowns
                              
                              
                              (148
                              )Balance,
      December 31, 2008
                              
                              $
                              3,285











Assets
measured at fair value on a nonrecurring basis are summarized
below.




Fair
      Value Measurements at December 31, 2008, UsingAssets
      at Fair Value at December 31, 2008
                              
                              
                              Quoted
      Prices in Active Markets for Identical Assets (Level 1)
                              
                              
                              Significant
      Other Observable Inputs (Level 2)
                              
                              
                              Significant
      Unobservable Inputs (Level 3)(in
      thousands)Assets:Impaired
      loans
                              
                              $
                              15,776
                              
                              
                              $
                              —
                              
                              
                              $
                              —
                              
                              
                              $
                              15,776Mortgage
      servicing rights
                              
                              
                              69
                              
                              
                              
                              —
                              
                              
                              
                              69
                              
                              
                              
                              —













The
Company measures for impairment using the fair value of the collateral for
collateral-dependent loans.  The Company’s impaired loans totaled
$20.2 million as of December 31, 2008, which included collateral-dependent loans
with a carrying value of $15.8 million.  As of December 31, 2008, the
Company’s collateral dependent loans had a valuation allowance of $4.4 million,
resulting in an additional provision for loan losses of $3.7 million during the
twelve months ended December 31, 2008.





























87
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE 16 - FAIR VALUE(Continued)





Fair
value of Financial Instruments





Carrying
amount and estimated fair values of financial instruments, not previously
presented, were as follows at year-end.





2008
                      
                      
                      2007Carrying
                        Amount
                      
                      
                      Fair
                        Value
                      
                      
                      Carrying
                        Amount
                      
                      
                      Fair
                        Value(In
      thousands)Financial
      assetsCash
      and due from financialinstitutions
                      
                      $
                      19,724
                      
                      
                      $
                      19,724
                      
                      
                      $
                      14,570
                      
                      
                      $
                      14,570Interest-bearing
      deposits inother
      financial institutions
                      
                      
                      45,749
                      
                      
                      
                      45,749
                      
                      
                      
                      13,943
                      
                      
                      
                      13,943Loans
      held for sale
                      
                      
                      308
                      
                      
                      
                      312
                      
                      
                      
                      757
                      
                      
                      
                      767Loans,
      net
                      
                      
                      623,103
                      
                      
                      
                      615,501
                      
                      
                      
                      629,732
                      
                      
                      
                      636,433Accrued
      interest receivable
                      
                      
                      3,163
                      
                      
                      
                      3,163
                      
                      
                      
                      3,537
                      
                      
                      
                      3,537Federal
      Home Loan Bank and  Federal Reserve Stock
                      
                      
                      8,472
                      
                      
                      
                      n/a
                      
                      
                      
                      8,096
                      
                      
                      
                      n/aFinancial
      liabilitiesDeposits
                      
                      
                      603,185
                      
                      
                      
                      589,537
                      
                      
                      
                      573,346
                      
                      
                      
                      565,741Other
      borrowings
                      
                      
                      78,983
                      
                      
                      
                      80,158
                      
                      
                      
                      72,796
                      
                      
                      
                      72,796Federal
      Home Loan BankAdvances
                      
                      
                      111,943
                      
                      
                      
                      116,007
                      
                      
                      
                      91,376
                      
                      
                      
                      94,431Subordinated
      debentures
                      
                      
                      17,000
                      
                      
                      
                      12,699
                      
                      
                      
                      17,000
                      
                      
                      
                      16,220Accrued
      interest payable
                      
                      
                      1,705
                      
                      
                      
                      1,705
                      
                      
                      
                      1,956
                      
                      
                      
                      1,956Interest
      rate swap
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      234
                      
                      
                      
                      234








The
methods and assumptions used to estimate fair value are described as
follows:





The
estimated fair value equals the carrying amount for cash and due from banks,
interest-bearing deposits in other financial institutions, accrued interest
receivable and payable, demand deposits, other borrowings, and variable rate
loans or deposits that reprice frequently and fully.  Interest rate
swap fair values are based on market prices or dealer quotes.  For
fixed rate loans or deposits and for variable rate loans or deposits with
infrequent repricing or repricing limits, fair value is based on discounted cash
flows using current market rates applied to the estimated life and credit
risk.  Fair value of loans held for sale is based on market
quotes.  It is not practical to determine the fair value of FHLB and
Federal Reserve stock due to restrictions placed on
transferability.  Fair value of FHLB advances and subordinated
debentures are based on current rates for similar financing.  The fair
value of off-balance-sheet items is based on current fees or costs that would be
charged to enter into or terminate such arrangements and is not
material.

















88
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE
17- PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION





Condensed
financial information for Community Bank Shares of Indiana, Inc. is as
follows:





CONDENSED
BALANCE SHEETS





December
      31,2008
                      
                      
                      2007(In
      thousands)ASSETSCash
      and due from financial institutions
                      
                      $
                      826
                      
                      
                      $
                      7Interest-bearing
      deposits in other financial institutions
                      
                      
                      5
                      
                      
                      
                      -Investment
      in subsidiaries
                      
                      
                      88,583
                      
                      
                      
                      88,217Other
      assets
                      
                      
                      799
                      
                      
                      
                      2,656Total
      assets
                      
                      $
                      90,213
                      
                      
                      $
                      90,880LIABILITIES
      AND SHAREHOLDERS’ EQUITYOther
      borrowings
                      
                      $
                      9,172
                      
                      
                      $
                      8,554Subordinated
      debentures
                      
                      
                      17,000
                      
                      
                      
                      17,000Accrued
      expenses and other liabilities
                      
                      
                      1,442
                      
                      
                      
                      861Total
      liabilities
                      
                      
                      27,614
                      
                      
                      
                      26,415Total
      shareholders’ equity
                      
                      
                      62,599
                      
                      
                      
                      64,465$
                      90,213
                      
                      
                      $
                      90,880





CONDENSED
STATEMENTS OF INCOME




Years
      ended December 31,2008
                        
                        
                        2007
                        
                        
                        2006Income
                        
                        (In
      thousands)Dividends
      from subsidiaries
                        
                        $
                        4,000
                        
                        
                        $
                        4,500
                        
                        
                        $
                        950ExpenseOperating
      expenses
                        
                        
                        2,669
                        
                        
                        
                        3,171
                        
                        
                        
                        2,057Income
      (loss) before income taxes and equityin
      undistributed net income of subsidiaries
                        
                        
                        1,331
                        
                        
                        
                        1,329
                        
                        
                        
                        (1,107
                        )Income
      tax benefit
                        
                        
                        864
                        
                        
                        
                        1,037
                        
                        
                        
                        668Income
      (loss) before equity in undistributed netincome
      of subsidiaries
                        
                        
                        2,195
                        
                        
                        
                        2,366
                        
                        
                        
                        (439
                        )Equity
      in undistributed net income (loss) of subsidiaries
                        
                        
                        (1,374
                        )
                        
                        
                        1,137
                        
                        
                        
                        4,550Net
      Income
                        
                        $
                        821
                        
                        
                        $
                        3,503
                        
                        
                        $
                        4,111



































89
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE 17 - PARENT COMPANY ONLY
CONDENSED FINANCIAL INFORMATION (Continued)





CONDENSED
STATEMENTS OF CASH FLOWS





Years
      ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006Cash
      flows from operating activities
                  
                  (In
      thousands)Net
      income
                  
                  $
                  821
                  
                  
                  $
                  3,503
                  
                  
                  $
                  4,111Adjustments
      to reconcile net income to net cashfrom
      operating activitiesEquity
      in undistributed net (income) loss of subsidiaries
                  
                  
                  1,374
                  
                  
                  
                  (1,137
                  )
                  
                  
                  (4,550
                  )Share-based
      compensation expense
                  
                  
                  309
                  
                  
                  
                  122
                  
                  
                  
                  332Net
      change in other assets and liabilities
                  
                  
                  2,297
                  
                  
                  
                  (1,415
                  )
                  
                  
                  63Net
      cash from operating activities
                  
                  
                  4,801
                  
                  
                  
                  1,073
                  
                  
                  
                  (44
                  )Cash
      flows from investing activitiesAcquisition
      of The Bancshares, Inc.
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (11,001
                  )Net
      change in interest-bearing deposits with banks
                  
                  
                  (5
                  )
                  
                  
                  -
                  
                  
                  
                  -Investment
      in subsidiary
                  
                  
                  (2,000
                  )
                  
                  
                  -
                  
                  
                  
                  -Net
      cash from investing activities
                  
                  
                  (2,005
                  )
                  
                  
                  
                  
                  
                  
                  (11,001
                  )Cash
      flows from financing activitiesNet
      change in short-term borrowings
                  
                  
                  618
                  
                  
                  
                  5,074
                  
                  
                  
                  3,480Proceeds
      from issuance of subordinated debenture
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  10,000Exercise
      of stock options
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  15Purchase
      of treasury stock
                  
                  
                  (400
                  )
                  
                  
                  (3,904
                  )
                  
                  
                  (685
                  )Tax
      benefit of stock options exercised
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  80Cash
      dividends paid
                  
                  
                  (2,195
                  )
                  
                  
                  (2,299
                  )
                  
                  
                  (1,921
                  )Net
      cash from financing activities
                  
                  
                  (1,977
                  )
                  
                  
                  (1,129
                  )
                  
                  
                  10,969Net
      change in cash
                  
                  
                  819
                  
                  
                  
                  (56
                  )
                  
                  
                  (76
                  )Cash
      at beginning of year
                  
                  
                  7
                  
                  
                  
                  63
                  
                  
                  
                  139Cash
      at end of year
                  
                  $
                  826
                  
                  
                  $
                  7
                  
                  
                  $
                  63














90
 Index
 COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006


NOTE
18 – EARNINGS PER SHARE





The
factors used in the earnings per share computation follows.





2008
                  
                  
                  2007
                  
                  
                  2006Basic
                  
                  (In
      thousands, except share and per share amounts)Net
      Income
                  
                  $
                  821
                  
                  
                  $
                  3,503
                  
                  
                  $
                  4,111Average
      shares:Common
      shares issued
                  
                  
                  3,863,942
                  
                  
                  
                  3,863,942
                  
                  
                  
                  3,436,051Less:  Treasury
      stock
                  
                  
                  (615,157
                  )
                  
                  
                  (514,521
                  )
                  
                  
                  (413,004
                  )Average
      shares outstanding
                  
                  
                  3,248,785
                  
                  
                  
                  3,349,421
                  
                  
                  
                  3,023,047Net
      income per common share, basic
                  
                  $
                  0.25
                  
                  
                  $
                  1.05
                  
                  
                  $
                  1.36DilutedNet
      Income
                  
                  $
                  821
                  
                  
                  $
                  3,503
                  
                  
                  $
                  4,111Average
      shares:Common
      shares outstanding for basic
                  
                  
                  3,248,785
                  
                  
                  
                  3,349,421
                  
                  
                  
                  3,023,047Add:  Dilutive
      effects of outstanding options
                  
                  
                  10,376
                  
                  
                  
                  24,802
                  
                  
                  
                  32,610Average
      shares and dilutive potentialcommon
      shares
                  
                  
                  3,259,161
                  
                  
                  
                  3,374,223
                  
                  
                  
                  3,055,657Net
      income per common share, diluted
                  
                  $
                  0.25
                  
                  
                  $
                  1.04
                  
                  
                  $
                  1.35








Stock
options of 241,000, 197,000, and 138,000 common shares were excluded from 2008,
2007, and 2006 diluted earnings per share because they were
anti-dilutive.





Performance
units of 22,500, 28,500, and 30,500 were excluded from 2008, 2007, and 2006
diluted earnings per share because all the conditions required for issuance at
those dates had not been met.







































































91
 Index COMMUNITY
BANK SHARES OF INDIANA, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 December
31, 2008, 2007 and 2006





NOTE
19 – OTHER COMPREHENSIVE INCOME (LOSS)





Other
comprehensive income (loss) components and related taxes were as
follows.





2008
                  
                  
                  2007
                  
                  
                  2006(In
      thousands)Unrealized
      holding gains (losses) on available forsale
      securities
                  
                  $
                  (27
                  )
                  
                  $
                  1,216
                  
                  
                  $
                  958Less
      reclassification adjustments for (gains) lossesrecognized
      in income
                  
                  
                  (364
                  )
                  
                  
                  41
                  
                  
                  
                  -Net
      unrealized gain (loss) on securities available forsale,
      net of reclassifications
                  
                  
                  (391
                  )
                  
                  
                  1,257
                  
                  
                  
                  958Unrealized
      holding gain (loss) on interest rate swaps
                  
                  
                  -
                  
                  
                  
                  44
                  
                  
                  
                  (473
                  )Amounts
      reclassified to interest income
                  
                  
                  -
                  
                  
                  
                  1,014
                  
                  
                  
                  1,061Net
      unrealized gain (loss) on interest rate swaps,net
      of reclassifications
                  
                  
                  -
                  
                  
                  
                  1,058
                  
                  
                  
                  588Change
      in minimum pension liability
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  125Unrealized
      loss on pension benefits
                  
                  
                  (212
                  )
                  
                  
                  (60
                  )
                  
                  
                  -Other
      comprehensive income (loss) before tax effects
                  
                  
                  (603
                  )
                  
                  
                  2,255
                  
                  
                  
                  1,671Tax
      effect
                  
                  
                  202
                  
                  
                  
                  (907
                  )
                  
                  
                  (574
                  )Other
      comprehensive income (loss)
                  
                  $
                  (401
                  )
                  
                  $
                  1,348
                  
                  
                  $
                  1,097





NOTE
20 – QUARTERLY FINANCIAL DATA (UNAUDITED)





Earnings
      (Loss) Per ShareInterest
                  Income
                
                
                Net
      Interest
                  Income
                
                
                Net
                  Income
      (Loss)
                
                
                Basic
                
                
                Diluted2008
                
                (In
      thousands, except per share amounts)First
      quarter
                
                $
                11,802
                
                
                $
                5,782
                
                
                $
                1,036
                
                
                $
                0.32
                
                
                $
                0.32Second
      quarter
                
                
                11,088
                
                
                
                5,886
                
                
                
                218
                
                
                
                0.07
                
                
                
                0.06Third
      quarter
                
                
                11,280
                
                
                
                5,946
                
                
                
                919
                
                
                
                0.28
                
                
                
                0.28Fourth
      quarter
                
                
                10,737
                
                
                
                5,840
                
                
                
                (1,352
                )
                
                
                (0.42
                )
                
                
                (0.42
                )2007First
      quarter
                
                $
                12,638
                
                
                $
                5,517
                
                
                $
                1,015
                
                
                $
                0.30
                
                
                $
                0.29Second
      quarter
                
                
                12,797
                
                
                
                5,669
                
                
                
                915
                
                
                
                0.27
                
                
                
                0.27Third
      quarter
                
                
                12,881
                
                
                
                5,593
                
                
                
                1,088
                
                
                
                0.33
                
                
                
                0.33Fourth
      quarter
                
                
                12,446
                
                
                
                5,588
                
                
                
                485
                
                
                
                0.15
                
                
                
                0.15





Net
income for the second and fourth quarters of 2008 and the fourth of 2007 were
substantially impacted by increased provision for loan losses in those periods
as compared to other periods in those years.  The provision for loan
losses for the second and fourth quarters of 2008 and the fourth quarter of 2007
were $1.9 million, $3.5 million, and $892,000, respectively.


92
 Index


Part II





Item
9.  Changes In And Disagreements With Accountants On Accounting And
Financial Disclosures





There has
been no change in the Company’s principal independent accountant during the
Company’s two most recent fiscal years.





Item
9A.  Controls And Procedures





Company
management, including the Chief Executive Officer (serving as the principal
executive officer) and Chief Financial Officer (serving as the principal
financial officer), have conducted an evaluation of the effectiveness of the
design and operation  of our disclosure controls and procedures
pursuant to Securities Exchange Act of 1934 Rule 13a-14. Based on that
evaluation, the Chief Executive Officer and the Chief Financial Officer
concluded that the disclosure controls and procedures are effective in timely
alerting them to material information required to be included in this
report.  There has been no change in the Company’s internal control
over financial reporting that occurred during the Company’s most recent fiscal
quarter that has materially affected or is reasonable likely to materially
affect the Company’s internal control over financial reporting.














































































































93
 Index





MANAGEMENT’S
REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING





Community
Bank Shares of Indiana’s (the Company’s) management is responsible for
establishing and maintaining adequate internal control over financial reporting.
Internal control over financial reporting is defined in Rule 13a-15(f) or
15d-15(f) under the Securities Exchange Act of 1934 as a process designed by, or
under the supervision of, the Company’s principal executive and principal
financial officers and effected by the Company’s Board of Directors, management
and other personnel, to provide reasonable assurance regarding the reliability
of financial reporting and the preparation of financial statements for external
purposes in accordance with U.S. generally accepted accounting principles and
includes those policies and procedures that:






            Pertain
      to the maintenance of records that in reasonable detail accurately and
      fairly reflect the transactions and dispositions of the Company’s
      assets;






            Provide
      reasonable assurance that transactions are recorded as necessary to permit
      preparation of financial statements in accordance with U.S. generally
      accepted accounting principles, and that receipts and expenditures of the
      Company are being made only in accordance with authorizations of
      management and directors of the Company;
and






            Provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use or disposition of the Company’s assets that
      could have a material effect on the financial
  statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Projections of any evaluation of effectiveness
to future periods are subject to the risk that controls may become inadequate
because of changes in conditions, or that the degree of compliance with the
policies or procedures may deteriorate.





Our
management, including our principal executive officer and principal financial
officer, assessed the effectiveness of our internal control over financial
reporting as of the end of the fiscal year covered by this annual report on Form
10-K. In making this assessment, our management used the criteria set forth in
Internal Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). Based on our management’s
assessment, management concluded that, as of December 31, 2008, our Company’s
internal control over financial reporting is effective based on the COSO
criteria.





This
annual report does not include an attestation report of the Company’s registered
public accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by the
Company’s registered public accounting firm pursuant to temporary rules of the
Securities and Exchange Commission that permit the Company to provide only
management’s report in this annual report.








/s/ James D.
      Rickard
                  
                  /s/ Paul A.
    ChriscoJames
      D. Rickard
                  
                  Paul
      A. ChriscoPresident
      and Chief Executive Officer
                  
                  Executive
      Vice President andChief
      Financial Officer



































94
 Index




Item
9B.  Other Information





There was
no information to be disclosed by the Company on a Form 8-K during the fourth
quarter of 2008 but not reported.





Part III





Item
10.  Directors, Executive Officers And Corporate
Governance





The
information regarding Company directors required by this item is incorporated
herein by reference to information under the headings “Corporate Governance and
Board Matters” and “Proposal No. 1 – Election of Directors” in our definitive
proxy statement, to be filed with the SEC, relating to our 2009 annual meeting
of shareholders (“2009 Proxy Statement”)the 2009 Proxy
Statement.  Information regarding the members of the Audit Committee,
the Company’s code of business conduct and ethics, the identification of the
Audit Committee Financial Expert and stockholder nominations of directors is
also incorporated by reference to the information under the aforesaid
headings.  The information regarding our executive officers required
by this item is incorporated by reference to the information in the 2009 Proxy
Statement.





Section 16(a) Beneficial
Ownership Reporting Compliance





Section
16(a) of the Securities Exchange Act of 1934, as amended, requires the Company’s
directors and executive officers and person who own more than 10% of the
Company’s common stock to file reports of ownership and changes in ownership
with the SEC.  Based solely upon a review of the Forms 3, 4 and 5
filed during 2008, and written representations from certain reporting persons
that no Forms 5 were required, the Company reasonably believes that all required
reports were timely filed.





Item
11.  Executive Compensation





Information
concerning executive compensation is incorporated herein by reference to the
information under the heading “EXECUTIVE COMPENSATION” in the 2009 Proxy
Statement.





Item
12.  Security Ownership Of Certain Beneficial Owners And Management
And Related Stockholder Matters





Information
concerning security ownership of management is incorporated herein by reference
to the information under the heading “STOCK OWNERSHIP BY DIRECTORS AND EXECUTIVE
OFFICERS” in the 2009 Proxy Statement.





Item
13.  Certain Relationships And Related Transactions, And Director
Independence





Information
concerning relationships and related transactions, and director independence is
incorporated herein by reference to the information under the headings
"COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION”, “CORPORATE
GOVERNANCE AND BOARD MATTERS” and “CERATIN RELATIONSHIPS AND RELATED PERSON
TRANSACTIONS” in the 2009 Proxy Statement.





Item
14.  Principal Accountant Fees And Services





Information
concerning principal accountant fees and services is incorporated herein by
reference to the information under the headings “REPORT OF THE AUDIT COMMITTEE”
and “RATIFICATION OF APPOINTMENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM” in the 2009 Proxy Statement.














95
 Index




Part IV





Item
15.  Exhibits And Financial Statement
Schedules





(a)(1)
Financial Statements





The
following financial statements are included in Item 8 of this Form
10-K:





Report of
Independent Registered Public Accounting Firm


Consolidated
Balance Sheets


Consolidated
Statements of Income


Consolidated
Statements of Changes in Shareholders’ Equity


Consolidated
Statements of Cash Flows


Notes to
Consolidated Financial Statements





(a)(2)
Financial Statement Schedules





All
financial statement schedules have been omitted as the required information is
inapplicable or the requiredinformation has been
included in the Consolidated Financial Statements or notes thereto.





(a) (3)
Exhibits


Reference
is made to the Exhibit Index beginning on Page E-1 hereof.





96
 Index


Signatures





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the Registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.




COMMUNITY
      BANK SHARES OF INDIANA,  INC.March
      31, 2009
                      By: /s/ James D. RickardJames
      D. RickardPresident
      and Chief Executive
Officer


Pursuant
to the requirements of the Securities Exchange of 1934, this report has been
signed below by the following persons on behalf of the Registrant and in the
capacities and on the dates indicated.




/s/ James D. Rickard
                                        President,
      Chief Executive Officer, and Director
                                        March
      31, 2009James
      D. Rickard
                                        (Principal
      Executive Officer)/s/ Paul A. Chrisco
                                        Senior
      Vice-President and Chief Financial Officer
                                        March
      31, 2009Paul
      A. Chrisco
                                        (Principal
      Financial and Accounting Officer)/s/ Timothy T. Shea
                                        Chairman
      of the Board of Directors and Director
                                        March
      31, 2009Timothy
      T. Shea/s/ Gary L. Libs
                                        Director
                                        March
      31, 2009Gary
      L. Libs/s/ R. Wayne Estopinal
                                        Director
                                        March
      31, 2009R.
      Wayne Estopinal/s/ George M. Ballard
                                        Director
                                        March
      31, 2009George
      M. Ballard/s/ Gordon L. Huncilman
                                        Director
                                        March
      31, 2009Gordon
      L. Huncilman/s/ Kerry M. Stemler
                                        Director
                                        March
      31, 2009Kerry
      M. Stemler/s/ Steven R. Stemler
                                        Director
                                        March
      31, 2009Steven
      R. Stemler/s/ Norman E. Pfau
                                        Director
                                        March
      31, 2009Norman
      E. Pfau









97
 Index





Exhibit Index


Exhibit
                Number
              Document
              Filed
                with
      this
                Form 10-K
              Incorporated By
ReferenceForm
              File No.
              Date Filed2.1
              Agreement
      and Plan of Merger between Community Bank Shares of Indiana, Inc., The
      Bancshares, Inc., and CBIN Subsidiary, Inc.
              
              8-K
              000-25766
              02/16/20063.1
              Articles
      of Incorporation
              
              8-K
              000-25766
              07/27/20073.2
              Bylaws
              
              8-K
              000-25766
              07/27/20074.0
              Common
      Stock Certificate
              
              8-K
              000-25766
              07/27/200710.1
              Employment
      Agreement with Dale Orem *
              
              10-K
              000-25766
              04/02/200210.2
              Employment
      Agreement with Robert E. Yates*
              
              10-K
              000-25766
              04/02/200210.3
              Employment
      Agreement James D. Rickard *
              
              10-Q
              000-25766
              11/14/200010.4
              Community
      Bank Shares of Indiana, Inc. 1997 Stock Incentive Plan *
              
              S-8
              333-
      60089
              07/29/199810.5
              Community
      Bank Shares of Indiana, Inc. Dividend Reinvestment Plan *
              
              S-3D
                S-3D
              333-40211
                333-130721
              11/14/1997
                12/28/200510.6
              Employment
      Agreement with Christopher L. Bottorff *
              
              10-K
              000-25766
              03/31/200310.7
              Employment
      Agreement with Kevin J. Cecil *
              
              10-K
              000-25766
              03/31/200410.8
              Employment
      Agreement with Paul A. Chrisco *
              
              10-K
              000-25766
              03/31/200410.9
              Consulting
      Agreement with Dale L. Orem *
              
              10-K
              000-25766
              03/31/200410.10
              Community
      Bank Shares of Indiana, Inc. and Affiliates Business Ethics
      Policy
              
              8-K
              000-25766
              04/24/200710.11
              Community
      Bank Shares of Indiana, Inc. 2005 Stock Award Plan
              
              Exh.
      B to
                DEF
      14A
              000-25766
              11/06/200610.12
              Amendment
      to Employment Agreement with James D. Rickard *
              
              8-K
              000-25766
              11/06/200610.13
              Amendment
      to Employment Agreement with Christopher L. Bottorff *
              
              8-K
              000-25766
              11/06/200610.14
              Amendment
      to Employment Agreement with Kevin J. Cecil *
              
              8-K
              000-25766
              11/06/200610.15
              Amendment
      to Employment Agreement with Paul A. Chrisco *
              
              8-K
              000-25766
              11/06/200610.16
              Amendment
      to Community Bank Shares of Indiana, Inc. Performance Units
      Plan
              
              8-K
              000-25766
              10/23/200611.1
              Computation
      of Earnings Per Share
              X21.0
              Subsidiaries
      of Registrant
              X23.1
              Consent
      of Crowe Horwath LLP
              X31.1
              Certification
      of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350 (As
      Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of
      2002)
              X31.2
              Certification
      of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350 (As
      Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of
      2002)
              X32.1
              Certification
      of Principal Executive Officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002
              X32.2
              Certification
      of Principal Financial Officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002
              X















*
Management contract or compensatory plan or arrangement required to be filed as
an exhibit to this Report pursuant to Item 601 of Regulation
S-K.


98