**UNITED STATES**

**SECURITIES ANDEXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-Q**

 

**(Mark One)**

 

**x**                              **QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934.**

 

**For the quarterly period ended March 31, 2008**

 

**OR**

 

**o**                                 **TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934.**

 

**CommissionFile Number 0-18832**

 

**First FinancialService Corporation**

(ExactName of Registrant as specified in its charter)

 

| **Kentucky**                      | ** ** | **61-1168311**                    |
|-----------------------------------|------------|-----------------------------------|
| (State or other jurisdiction      |       | (IRS Employer Identification No.) |
| of incorporation or organization) |       |                              |

 

**2323 Ring Road**

**Elizabethtown, Kentucky 42701**

(Addressof principal executive offices)

(ZipCode)

 

**(270)765-2131**

(Registrant’s telephonenumber, including area code)

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes  x  No  o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. Seedefinitions of “large accelerated filer,” “accelerated filer,” and “smallerreporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

| Large accelerated filer  o                     |   | Accelerated filer x          |
|------------------------------------------------|--------|-----------------------------------|
|                                           |   |                              |
| Non-accelerated filer o                        |   | Smaller reporting  company o |
| (Do not check if a  smaller reporting company) |   |                              |

 

Indicate by a check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o  No  x

 

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

 
| **Class**    | ** ** | **Outstanding as of April 30, 2008** | ** ** |
|--------------|------------|---------------------------------------------------------------|------------|
|         |       |                                                          |       |
| Common Stock |       | 4,664,235 shares                                              |       |

 

 

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## **FIRST FINANCIAL SERVICE CORPORATION**

**FORM 10-Q**

**TABLE OF CONTENTS**

 
| **PART I** – **FINANCIAL INFORMATION**       |
|--------------------------------------------------------|
|                                                   |   |
| Preliminary  Note Regarding Forward-Looking Statements |
|                                                   |   |
| **Item 1.**                                            | Consolidated Financial Statements and  Notes to Consolidated Financial Statements |
|                                                   |   |
| **Item 2.**                                            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
|                                                   |   |
| **Item 3.**                                            | Quantitative  and Qualitative Disclosures about Market Risk |
|                                                   |   |
| **Item 4.**                                            | Controls and  Procedures |
|                                                   |   |
| **PART II–  OTHER INFORMATION**              |
|                                                   |   |
| **Item 1.**                                            | Legal Proceedings |
|                                                   |   |
| **Item 1A.**                                           | Risk Factors |
|                                                   |   |
| **Item 2.**                                            | Unregistered Sales of Equity Securities and Use of Proceeds |
|                                                   |   |
| **Item 3.**                                            | Defaults upon Senior Securities |
|                                                   |   |
| **Item 4.**                                            | Submission of Matters to a Vote of Security Holders |
|                                                   |   |
| **Item 5.**                                            | Other Information |
|                                                   |   |
| **Item 6.**                                            | Exhibits |
|                                                   |   |
| **SIGNATURES**                                         |
|                                                        |  |  |

 

2

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**PRELIMINARY NOTE REGARDINGFORWARD-LOOKING STATEMENTS**

 

Statementsin this report that are not statements of historical fact are forward-lookingstatements. First Financial Service Corporation (the “Corporation”) may makeforward-looking statements in future filings with the Securities and ExchangeCommission (“SEC”), in press releases, and in oral and written statements madeby or with the approval of the Corporation. Forward-looking statements include, but are not limited to: (1) projectionsof revenues, income or loss, earnings or loss per share, capital structure andother financial items; (2) plans and objectives of the Corporation or itsmanagement or Board of Directors; (3) statements regarding future events,actions or economic performance; and (4) statements of assumptionsunderlying such statements.  Words suchas “estimate,” “strategy,” “believes,” “anticipates,” “expects,” “intends,” “plans,”“targeted,” and similar expressions are intended to identify forward-lookingstatements, but are not the exclusive means of identifying such statements.

 

Variousrisks and uncertainties may cause actual results to differ materially fromthose indicated by our forward-looking statements.  In addition to those risks described under “Item1A Risk Factors,” of this report, the following factors could cause suchdifferences: changes in general economic conditions and economic conditions inKentucky and the markets we serve, any of which may affect, among other things,our level of non-performing assets, charge-offs, and provision for loan lossexpense; changes in interest rates that may reduce interest margins and impactfunding sources; changes in market rates and prices which may adversely impactthe value of financial products including securities, loans and deposits;changes in tax laws, rules and regulations; various monetary and fiscalpolicies and regulations, including those determined by the Federal ReserveBoard, the Federal Deposit Insurance Corporation (“FDIC”) and the KentuckyOffice of Financial Institutions (“KOFI”); competition with other local andregional commercial banks, savings banks, credit unions and other non-bankfinancial institutions; our ability to grow core businesses; our ability todevelop and introduce new banking-related products, services and enhancementsand gain market acceptance of such products; and management’s ability to managethese and other risks.

 

Ourforward-looking statements speak only as of the date on which they are made,and we undertake no obligation to update any forward-looking statement toreflect events or circumstances after the date of the statement to reflect theoccurrence of unanticipated events.

 

3

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**Item 1.**

 

**FIRSTFINANCIAL SERVICE CORPORATION**

**ConsolidatedBalance Sheets**

**(Unaudited)**

 
| ** **                                                                                                                                                 | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| **(Dollars in thousands, except share data)**                                                                                     | ** ** | **2008**           | ** ** | **2007**              | ** ** |
|                                                                                                                                                       |       |               |       |                  |       |
| **ASSETS:**                                                                                                                                                |       |               |       |                  |       |
| Cash and due  from banks                                                                                                                                   |       | $                  | 18,304     |                  | $          | 14,948 |   |
|                                                                                                                                                       |       |               |       |                  |       |
| Securities  available-for-sale                                                                                                                             |       | 21,701             |       | 22,004                |       |
| Securities held-to-maturity,  fair value of $6,496 Mar (2008) and $17,624 Dec (2007)                                                                       |       | 6,418              |       | 17,681                |       |
| Total securities                                                                                                                                           |       | 28,119             |       | 39,685                |       |
|                                                                                                                                                       |       |               |       |                  |       |
| Loans held for  sale                                                                                                                                       |       | 4,923              |       | 780                   |       |
| Loans, net of  unearned fees                                                                                                                               |       | 777,968            |       | 767,256               |       |
| Allowance for  loan losses                                                                                                                                 |       | (8,395             | )          | (7,922                | )          |
| Net loans                                                                                                                                                  |       | 774,496            |       | 760,114               |       |
|                                                                                                                                                       |       |               |       |                  |       |
| Federal Home  Loan Bank stock                                                                                                                              |       | 7,721              |       | 7,621                 |       |
| Cash surrender  value of life insurance                                                                                                                    |       | 8,381              |       | 8,290                 |       |
| Premises and  equipment, net                                                                                                                               |       | 27,306             |       | 26,335                |       |
| Real estate  owned:                                                                                                                                        |       |               |       |                  |       |
| Acquired through  foreclosure                                                                                                                              |       | 3,021              |       | 1,749                 |       |
| Held for  development                                                                                                                                      |       | 45                 |       | 45                    |       |
| Other  repossessed assets                                                                                                                                  |       | 74                 |       | 52                    |       |
| Goodwill                                                                                                                                                   |       | 8,384              |       | 8,384                 |       |
| Accrued interest  receivable                                                                                                                               |       | 3,886              |       | 4,324                 |       |
| Other assets                                                                                                                                               |       | 1,894              |       | 1,144                 |       |
|                                                                                                                                                       |       |               |       |                  |       |
| **TOTAL  ASSETS**                                                                                                                                          |       | $                  | 881,631    |                  | $          | 872,691 |   |
|                                                                                                                                                       |       |               |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                              |       |               |       |                  |       |
| **LIABILITIES:**                                                                                                                                           |       |               |       |                  |       |
| Deposits:                                                                                                                                                  |       |               |       |                  |       |
| Non-interest  bearing                                                                                                                                      |       | $                  | 58,062     |                  | $          | 46,978 |   |
| Interest bearing                                                                                                                                           |       | 646,943            |       | 642,265               |       |
| Total deposits                                                                                                                                             |       | 705,005            |       | 689,243               |       |
|                                                                                                                                                       |       |               |       |                  |       |
| Short-term  borrowings                                                                                                                                     |       | 34,400             |       | 42,800                |       |
| Advances from  Federal Home Loan Bank                                                                                                                      |       | 53,049             |       | 53,083                |       |
| Subordinated  debentures                                                                                                                                   |       | 10,000             |       | 10,000                |       |
| Accrued interest  payable                                                                                                                                  |       | 654                |       | 1,093                 |       |
| Accounts payable  and other liabilities                                                                                                                    |       | 2,557              |       | 1,789                 |       |
| Deferred income  taxes                                                                                                                                     |       | 1,285              |       | 1,223                 |       |
|                                                                                                                                                       |       |               |       |                  |       |
| **TOTAL  LIABILITIES**                                                                                                                                     |       | 806,950            |       | 799,231               |       |
| Commitments and  contingent liabilities                                                                                                                    |       | —             |       | —                |       |
|                                                                                                                                                       |       |               |       |                  |       |
| **STOCKHOLDERS’  EQUITY:**                                                                                                                            |       |               |       |                  |       |
| Serial preferred stock, 5,000,000 shares authorized  and unissued                                                                                          |       | —             |       | —                |       |
| Common stock, $1  par value per share; authorized 10,000,000 shares; issued and outstanding,  4,664,235 shares (Mar 2008), and 4,661,083 shares (Dec 2007) |       | 4,664              |       | 4,661                 |       |
| Additional  paid-in capital                                                                                                                                |       | 33,987             |       | 33,886                |       |
| Retained  earnings                                                                                                                                         |       | 36,222             |       | 35,225                |       |
| Accumulated  other comprehensive loss                                                                                                                      |       | (192               | )          | (312                  | )          |
|                                                                                                                                                       |       |               |       |                  |       |
| **TOTAL  STOCKHOLDERS’ EQUITY**                                                                                                                       |       | 74,681             |       | 73,460                |       |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                       |       | $                  | 881,631    |                  | $          | 872,691 |   |

 

*Seenotes to the unaudited consolidated financial statements.*

 

4

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**FIRSTFINANCIAL SERVICE CORPORATION**

**Consolidated Statements of Income**

**(Unaudited)**

 
| ** **                                                                      | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------|------------|
| **(Dollars in thousands, except per share data)** | ** ** | **March 31,**               | ** ** |
| ** **                                                                      | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| **Interest  and Dividend Income:**                                              |       |                             |       |   |   |
| Loans, including  fees                                                          |       | $                                | 14,032     |   | $ | 13,941 |   |
| Taxable  securities                                                             |       | 384                              |       | 612 |   |
| Tax exempt  securities                                                          |       | 100                              |       | 108 |   |
| Total interest  income                                                          |       | 14,516                           |       | 14,661 |   |
|                                                                            |       |                             |       |   |   |
| **Interest  Expense:**                                                          |       |                             |       |   |   |
| Deposits                                                                        |       | 5,686                            |       | 5,946 |   |
| Short-term  borrowings                                                          |       | 322                              |       | 575 |   |
| Federal Home  Loan Bank advances                                                |       | 596                              |       | 336 |   |
| Subordinated  debentures                                                        |       | 167                              |       | 228 |   |
| Total interest  expense                                                         |       | 6,771                            |       | 7,085 |   |
|                                                                            |       |                             |       |   |   |
| Net interest  income                                                            |       | 7,745                            |       | 7,576 |   |
| Provision for  loan losses                                                      |       | 584                              |       | 81 |   |
| Net interest  income after provision for loan losses                            |       | 7,161                            |       | 7,495 |   |
|                                                                            |       |                             |       |   |   |
| **Non-interest  Income:**                                                       |       |                             |       |   |   |
| Customer service  fees on deposit accounts                                      |       | 1,416                            |       | 1,273 |   |
| Gain on sale of  mortgage loans                                                 |       | 148                              |       | 126 |   |
| Gain on sale of  real estate held for development                               |       | —                           |       | 227 |   |
| Brokerage  commissions                                                          |       | 118                              |       | 97 |   |
| Other income                                                                    |       | 272                              |       | 222 |   |
| Total  non-interest income                                                      |       | 1,954                            |       | 1,945 |   |
|                                                                            |       |                             |       |   |   |
| **Non-interest  Expense:**                                                      |       |                             |       |   |   |
| Employee  compensation and benefits                                             |       | 3,418                            |       | 3,124 |   |
| Office occupancy  expense and equipment                                         |       | 653                              |       | 566 |   |
| Marketing and  advertising                                                      |       | 214                              |       | 271 |   |
| Outside services  and data processing                                           |       | 717                              |       | 666 |   |
| Bank franchise  tax                                                             |       | 250                              |       | 231 |   |
| Write off of  issuance cost of Trust Preferred Securities                       |       | —                           |       | 229 |   |
| Other expense                                                                   |       | 1,083                            |       | 928 |   |
| Total  non-interest expense                                                     |       | 6,335                            |       | 6,015 |   |
|                                                                            |       |                             |       |   |   |
| Income before  income taxes                                                     |       | 2,780                            |       | 3,425 |   |
| Income taxes                                                                    |       | 897                              |       | 1,108 |   |
| **Net  Income**                                                                 |       | $                                | 1,883      |   | $ | 2,317 |   |
|                                                                            |       |                             |       |   |   |
| Shares  applicable to basic income per share (1)                                |       | 4,663,447                        |       | 4,797,434 |   |
| **Basic  income per share (1)**                                                 |       | $                                | 0.40       |   | $ | 0.48 |   |
|                                                                            |       |                             |       |   |   |
| Shares  applicable to diluted income per share (1)                              |       | 4,697,876                        |       | 4,848,711 |   |
| **Diluted  income per share (1)**                                               |       | $                                | 0.40       |   | $ | 0.48 |   |
|                                                                            |       |                             |       |   |   |
| **Cash  dividends declared per share (1)**                                      |       | $                                | 0.190      |   | $ | 0.173 |   |

 

----

**(1)  Adjusted to reflect theimpact of the 10% stock dividend declared August 16, 2007.**

 

*See notes to the unauditedconsolidated financial statements.*

 

5

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**FIRST FINANCIAL SERVICE CORPORATION**

**Consolidated Statements ofComprehensive Income**

**(Unaudited)**

 
| ** **                                                         | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                         | ** ** | **March 31,**               | ** ** |
| **(Dollars in thousands)**                               | ** ** | **2008**                         | ** ** | **2007** | ** ** |
|                                                               |       |                             |       |   |   |
| **Net Income**                                                     |       | $                                | 1,883      |   | $ | 2,317 |   |
| Other  comprehensive income (loss):                                |       |                             |       |   |   |
| Change in  unrealized gain (loss) on securities available-for-sale |       | 181                              |       | (9 | ) |
| Reclassification  of realized amount                               |       | —                           |       | — |   |
| Net unrealized  gain (loss) recognized in comprehensive income     |       | 181                              |       | (9 | ) |
| Tax effect                                                         |       | (61                              | )          | 3 |   |
| Total other  comphrehensive income (loss)                          |       | 120                              |       | (6 | ) |
|                                                               |       |                             |       |   |   |
| **Comprehensive  Income**                                          |       | $                                | 2,003      |   | $ | 2,311 |   |

 

*See notesto the unaudited consolidated financial statements.*

 

6

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**FIRSTFINANCIAL SERVICE CORPORATION**

**ConsolidatedStatement of Changes in Stockholders’ Equity**

**ThreeMonths Ended March 31, 2008**

**(DollarsIn Thousands, Except Per Share Amounts)**

**(Unaudited)**

 
| ** **                                                                            | ** ** | **Common  Shares ** | ** ** | **Stock  Amount** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  (Loss), Net of Tax** | ** ** | **Total** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------|------------|-------------------|------------|----------------------------------|------------|------------------------|------------|--------------------------------------------------------------------------|------------|-----------|------------|
|                                                                                  |       |                     |       |              |       |                             |       |                   |       |                                                                     |       |      |       |
| **Balance,  January 1, 2008**                                                    |       | 4,661                    |       | $                 | 4,661      |                             | $          | 33,886                 |       | $                                                                        | 35,225     |      | $          | (312 | ) | $ | 73,460 |   |
| Net income                                                                            |       |                     |       |              |       |                             |       | 1,883                  |       |                                                                     |       | 1,883     |       |
| Stock issued for  employee benefit plans                                              |       | 3                        |       | 3                 |       | 65                               |       |                   |       |                                                                     |       | 68        |       |
| Stock-based  compensation expense                                                     |       |                     |       |              |       | 36                               |       |                   |       |                                                                     |       | 36        |       |
| Net change in  unrealized gains (losses) on securities available-for-sale, net of tax |       |                     |       |              |       |                             |       |                   |       | 120                                                                      |       | 120       |       |
| Cash dividends  declared ($.19 per share)                                             |       | —                   |       | —            |       | —                           |       | (886                   | )          | —                                                                   |       | (886      | )          |
| **Balance,  March 31, 2008**                                                     |       | 4,664                    |       | $                 | 4,664      |                             | $          | 33,987                 |       | $                                                                        | 36,222     |      | $          | (192 | ) | $ | 74,681 |   |

 

*Seenotes to the unaudited consolidated financial statements.*

 

7

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**FIRST FINANCIAL SERVICE CORPORATION**

**Consolidated Statements of Cash Flows**

**(Dollars In Thousands)**

**(Unaudited)**

 
| ** **                                                                         | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                         | ** ** | **March 31,**               | ** ** |
| ** **                                                                         | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| **Operating  Activities:**                                                         |       |                             |       |   |   |
| Net income                                                                         |       | $                                | 1,883      |   | $ | 2,317 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                             |       |   |   |
| Provision for  loan losses                                                         |       | 584                              |       | 81 |   |
| Depreciation on  premises and equipment                                            |       | 361                              |       | 367 |   |
| Federal Home  Loan Bank stock dividends                                            |       | (100                             | )          | — |   |
| Net amortization  (accretion) available-for-sale                                   |       | 1                                |       | 1 |   |
| Net amortization  (accretion) held-to-maturity                                     |       | 3                                |       | 6 |   |
| Gain on sale of  real estate held for development                                  |       | —                           |       | (227 | ) |
| Gain on sale of  mortgage loans                                                    |       | (148                             | )          | (126 | ) |
| Origination of  loans held for sale                                                |       | (11,983                          | )          | (7,224 | ) |
| Proceeds on sale  of loans held for sale                                           |       | 7,988                            |       | 6,723 |   |
| Stock-based  compensation expense                                                  |       | 36                               |       | 26 |   |
| Changes in:                                                                        |       |                             |       |   |   |
| Cash surrender  value of life insurance                                            |       | (91                              | )          | (83 | ) |
| Interest  receivable                                                               |       | 438                              |       | 95 |   |
| Other assets                                                                       |       | (749                             | )          | (553 | ) |
| Interest payable                                                                   |       | (439                             | )          | (27 | ) |
| Accounts payable  and other liabilities                                            |       | 768                              |       | 1,177 |   |
| Net cash from  operating activities                                                |       | (1,448                           | )          | 2,553 |   |
|                                                                               |       |                             |       |   |   |
| **Investing  Activities:**                                                         |       |                             |       |   |   |
| Purchases of  securities available-for-sale                                        |       | —                           |       | (395 | ) |
| Maturities of  securities available-for-sale                                       |       | 484                              |       | 1,475 |   |
| Maturities of  securities held-to-maturity                                         |       | 11,260                           |       | 202 |   |
| Net change in  loans                                                               |       | (12,118                          | )          | (23,199 | ) |
| Net purchases of  premises and equipment                                           |       | (1,332                           | )          | (908 | ) |
| Sales of real  estate for development                                              |       | —                           |       | 473 |   |
| Net cash from  investing activities                                                |       | (1,706                           | )          | (22,352 | ) |
|                                                                               |       |                             |       |   |   |
| **Financing  Activities**                                                          |       |                             |       |   |   |
| Net change in  deposits                                                            |       | 15,762                           |       | 54,146 |   |
| Change in  short-term borrowings                                                   |       | (8,400                           | )          | (35,800 | ) |
| Repayments to  Federal Home Loan Bank                                              |       | (34                              | )          | (37 | ) |
| Proceeds from  issuance of subordinated debentures                                 |       | —                           |       | 10,000 |   |
| Payoff of  subordinated debentures                                                 |       | —                           |       | (10,000 | ) |
| Issuance of  common stock for employee benefit plans                               |       | 68                               |       | 88 |   |
| Dividends paid                                                                     |       | (886                             | )          | (830 | ) |
| Common stock  repurchased                                                          |       | —                           |       | (1,801 | ) |
| Net cash from  financing activities                                                |       | 6,510                            |       | 15,766 |   |
|                                                                               |       |                             |       |   |   |
| **(Decrease)  Increase in cash and cash equivalents**                              |       | 3,356                            |       | (4,033 | ) |
| **Cash  and cash equivalents, beginning of period**                                |       | 14,948                           |       | 19,082 |   |
| **Cash  and cash equivalents, end of period**                                      |       | $                                | 18,304     |   | $ | 15,049 |   |

 

*Seenotes to the unaudited consolidated financial statements.*

 

8

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.****                                     ****BASIS OF PRESENTATION ANDSUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

***Basis of Presentation*** – The accompanying unaudited consolidated financial statements include the accounts of First Financial Service Corporation and its wholly owned subsidiary, First Federal Savings Bank.  First Federal Savings Bank has two wholly owned subsidiaries, First Service Corporation of Elizabethtown and First Federal Office Park, LLC.  Unless the text clearly suggests otherwise, references to “us,” “we,” or “our” include First Financial Service Corporation and its wholly-owned subsidiary.  All significant intercompany transactions and balances have been eliminated in consolidation.

 

Theaccompanying unaudited consolidated financial statements have been prepared inaccordance with U.S. generally accepted accounting principles for interimfinancial information and with the instructions to Form 10-Q and Rule 10-01of Regulation S-X.  Accordingly, they donot include all of the information and footnotes required by U.S. generallyaccepted accounting principles for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included. Operating results for the three-month period ending March 31, 2008are not necessarily indicative of the results that may occur for the yearending December 31, 2008.  Forfurther information, refer to the consolidated financial statements andfootnotes thereto included in the Corporation’s annual report on Form 10-Kfor the period ended December 31, 2007.

 

***Stock Dividend***– We declared a 10% stock dividend on August 16,2007 to our shareholders of record as of August 29, 2007, payable on September 14,2007.  The payment of this dividend wasin addition to the regular quarterly cash dividend.  Per share amounts have been restated for theimpact of the stock dividend.

 

Stockdividends for 20% or less are reported by transferring the fair value, as ofthe dividend date, of the stock issued from retained earnings to common stockand additional paid-in-capital. Fractional share amounts are paid in cash with a reduction to retainedearnings.

 

***Adoption of New Accounting Standards***– We adopted the provisions of SFAS No. 157,“Fair Value Measurements” (“SFAS No. 157”) on January 1, 2008.  The adoption of SFAS No. 157 had noeffect on our financial statements. SFAS No. 157 defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles (GAAP), and expands disclosures about fair valuemeasurements.  More specifically, thisstatement clarifies the definition of fair value, establishes a fair valuationhierarchy based upon observable (e.g. quoted prices, interest rates, yieldcurves) and unobservable market inputs, and expands disclosure requirements toinclude the inputs used to develop estimates of fair value and the effects ofthe estimates on income for the period. This statement does not require any newfair value measurements.

 

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 157for all nonfinancial assets and nonfinancial liabilities, except those that arerecognized or disclosed at fair value on a recurring basis (at least annually)to fiscal years beginning after November 15, 2008, and interim periods withinthose fiscal years.

 

In February 2007, theFASB issued SFAS 159, “The Fair ValueOption for Financial Assets and Financial Liabilities — Including an amendmentof FASB Statement No. 115.”****Thisstatement allows companies to record certain financial assets and financialliabilities at full fair value if they so choose. The statement was issued tomitigate volatility in reported earnings caused by an accounting modelutilizing multiple measurement attributes. The adoption of the fair valueoption is recorded as a cumulative-effect adjustment to the opening balance ofretained earnings, which would be January 1, 2008. Upon adoption, thedifference between the carrying amount and the fair value of the items chosenis removed from the balance sheet and included in the cumulative-effectadjustment. Subsequent changes in fair value are recorded through the incomestatement. We did not elect the fair value option for any financial assets orfinancial liabilities as of January 1, 2008.

 

In September 2006, theFASB Emerging Issues Task Force finalized Issue No. 06-4, “Accounting forDeferred Compensation and Postretirement Benefit Aspects of EndorsementSplit-Dollar Life Insurance Arrangements.” This issue requires that a liability be recorded during the serviceperiod when a split-dollar life insurance agreement continues afterparticipants’ employment or retirement. The required accrued liability will be based on either thepost-employment benefit cost for the continuing life insurance or based on thefuture death benefit depending on the contractual terms of the underlyingagreement.  This issue is effective forfiscal years beginning after December 15, 2007.  The impact of adoption was not material.

 

9

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**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

 

***RecentAccounting Pronouncements***– In December 2007, the FASB issued SFAS 141 (revised 2007), *Business Combinations*(*SFAS 141R*). SFAS 141R establishesprinciples and requirements for how the acquirer of a business recognizes andmeasures in its financial statements the identifiable assets acquired, theliabilities assumed, and any non-controlling interest in the acquiree. SFAS141R also provides guidance for recognizing and measuring the goodwill acquiredin the business combination and determines what information to disclose toenable users of the financial statements to evaluate the nature and financialeffects of the business combination. SFAS 141R is effective for businesscombinations where the acquisition date is on or after fiscal years beginningafter December 15, 2008. SFAS******141Ris expected to have an impact on our accounting for any business combinationsclosing on or after January 1, 2009.

 

In December 2007, theFASB issues SFAS 160, *Non-controllingInterests in Consolidated Financial Statements– an amendment of ARB No. 51(SFAS 160)*. SFAS 160 establishes accounting and reporting standardsfor the non-controlling interest in a subsidiary and for the deconsolidation ofa subsidiary. SFAS 160 clarifies that a non-controlling interest in asubsidiary is an ownership interest in the consolidated entity that should bereported as equity in the consolidated financial statements and requiresretroactive adoption of the presentation and disclosure requirements forexisting minority interests. All other requirements of SFAS 160 shall beapplied prospectively. SFAS 160 is effective for fiscal year beginning after December 15,2008.

 

10

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** **

**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(CONTINUED)**

 

**2.**                                      **SECURITIES**

 

The amortized cost basis andfair values of securities are as follows:

 
| ** **                           | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** **          | ** ** |
|--------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|---------------------|------------|
| ** **                           | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | ** **          | ** ** |
| **(Dollars in thousands)** | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Fair Value** | ** ** |
| **Securities  available-for-sale:**  |       |          |       |           |       |           |       |                |       |
| **March 31,  2008:**            |       |          |       |           |       |           |       |                |       |
| U. S. Treasury  and agencies         |       | $             | 497        |           | $          | 3              |       | $                   | —     |   | $ | 500 |   |
| Mortgage-backed                      |       | 7,254         |       | 96             |       | (10            | )          | 7,340               |       |
| Equity                               |       | 1,553         |       | 244            |       | (94            | )          | 1,703               |       |
| State and  municipal                 |       | 9,885         |       | 5              |       | (535           | )          | 9,355               |       |
| Corporate                            |       | 2,803         |       | —         |       | —         |       | 2,803               |       |
|                                 |       |          |       |           |       |           |       |                |       |
| Total                                |       | $             | 21,992     |           | $          | 348            |       | $                   | (639       | ) | $ | 21,701 |   |
|                                 |       |          |       |           |       |           |       |                |       |
| **December 31,  2007:**         |       |          |       |           |       |           |       |                |       |
| U.S. Treasury  and agencies          |       | $             | 498        |           | $          | 3              |       | $                   | —     |   | $ | 501 |   |
| Mortgage-backed                      |       | 7,624         |       | 5              |       | (53            | )          | 7,576               |       |
| Equity                               |       | 1,553         |       | 324            |       | (355           | )          | 1,522               |       |
| State and  municipal                 |       | 9,994         |       | 4              |       | (400           | )          | 9,598               |       |
| Corporate                            |       | 2,807         |       | —         |       | —         |       | 2,807               |       |
|                                 |       |          |       |           |       |           |       |                |       |
| Total                                |       | $             | 22,476     |           | $          | 336            |       | $                   | (808       | ) | $ | 22,004 |   |

 
| ** **                        | ** ** | ** **    | ** ** | **Gross**        | ** ** | **Gross**        | ** ** | ** **     | ** ** |
|-----------------------------------|------------|---------------|------------|------------------|------------|------------------|------------|----------------|------------|
| ** **                        | ** ** | **Amortized** | ** ** | **Unrecognized** | ** ** | **Unrecognized** | ** ** | ** **     | ** ** |
| ** **                        | ** ** | **Cost**      | ** ** | **Gains**        | ** ** | **Losses**       | ** ** | **Fair Value** | ** ** |
| **Securities  held-to-maturity:** |       |          |       |             |       |             |       |           |       |
| **March 31,  2008:**         |       |          |       |             |       |             |       |           |       |
| U.S. Treasury  and agencies       |       | $             | 3,999      |             | $          | 101              |       | $              | —     |   | $ | 4,100 |   |
| Mortgage-backed                   |       | 2,140         |       | 2                |       | (3               | )          | 2,139          |       |
| Corporate                         |       | 279           |       | —           |       | (22              | )          | 257            |       |
|                              |       |          |       |             |       |             |       |           |       |
| Total                             |       | $             | 6,418      |             | $          | 103              |       | $              | (25        | ) | $ | 6,496 |   |
|                              |       |          |       |             |       |             |       |           |       |
| **December 31,  2007:**      |       |          |       |             |       |             |       |           |       |
| U.S. Treasury  and agencies       |       | $             | 14,098     |             | $          | 33               |       | $              | (38        | ) | $ | 14,093 |   |
| Mortgage-backed                   |       | 3,142         |       | 1                |       | (51              | )          | 3,092          |       |
| Corporate                         |       | 441           |       | —           |       | (2               | )          | 439            |       |
|                              |       |          |       |             |       |             |       |           |       |
| Total                             |       | $             | 17,681     |             | $          | 34               |       | $              | (91        | ) | $ | 17,624 |   |

 

11

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(CONTINUED)**

 

**3.****                                     ****LOANS**

 

Loans are summarized asfollows:

** **
| ** **                           | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|--------------------|------------|-----------------------|------------|
| **(Dollars in thousands)** | ** ** | **2008**           | ** ** | **2007**              | ** ** |
|                                 |       |               |       |                  |       |
| Commercial                           |       | $                  | 51,892     |                  | $          | 52,595 |   |
| Real estate  commercial              |       | 493,385            |       | 470,929               |       |
| Real estate  construction            |       | 17,382             |       | 21,383                |       |
| Residential  mortgage                |       | 127,612            |       | 132,329               |       |
| Consumer and  home equity            |       | 61,654             |       | 63,090                |       |
| Indirect  consumer                   |       | 26,853             |       | 27,721                |       |
| Loans held for  sale                 |       | 4,923              |       | 780                   |       |
|                                 |       | 783,701            |       | 768,827               |       |
| Less:                                | ** ** | ** **         | ** ** | ** **            | ** ** |
| Net deferred  loan origination fees  |       | (810               | )          | (791                  | )          |
| Allowance for  loan losses           |       | (8,395             | )          | (7,922                | )          |
|                                 |       | (9,205             | )          | (8,713                | )          |
| ** **                           | ** ** | ** **         | ** ** | ** **            | ** ** |
| Net Loans                            |       | $                  | 774,496    |                  | $          | 760,114 |   |

 

The allowance for loan loss is summarized asfollows:

 
| ** **                           | ** ** | **As of and For the** | ** ** |
|--------------------------------------|------------|-------------------------------------------|------------|
| ** **                           | ** ** | **Three Months Ended**          | ** ** |
| ** **                           | ** ** | **March 31,**                        | ** ** |
| **(Dollars in thousands)** | ** ** | **2008**                                  | ** ** | **2007** | ** ** |
|                                 |       |                                      |       |   |   |
| Balance,  beginning of period        |       | $                                         | 7,922      |   | $ | 7,684 |   |
| Provision for  loan losses           |       | 584                                       |       | 81 |   |
| Charge-offs                          |       | (149                                      | )          | (106 | ) |
| Recoveries                           |       | 38                                        |       | 71 |   |
| Balance, end of  period              |       | $                                         | 8,395      |   | $ | 7,730 |   |

 

Impaired loans are summarized below. There were no impaired loans for the periods presented without anallowance allocation.

 
| ** **                                   | ** ** | **As of and For the** | ** ** | **As of and For the** | ** ** |
|----------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                   | ** ** | **Three Months Ended**          | ** ** | **Year Ended**                       | ** ** |
| ** **                                   | ** ** | **March 31,**                        | ** ** | **December 31,**                     | ** ** |
| **(Dollars in thousands)**         | ** ** | **2008**                                  | ** ** | **2007**                                  | ** ** |
|                                         |       |                                      |       |                                      |       |
| End of period  impaired loans                |       | $                                         | 5,558      |                                      | $          | 8,889 |   |
| Amount of  allowance for loan loss allocated |       | 197                                       |       | 117                                       |       |
|                                              |            |                                           |            |                                           |            |  |  |

 

12

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(CONTINUED)**

 

**3.****                                     ****LOANS - (Continued)**

 

We report non-performingloans as impaired.  Our non-performingloans were as follows:

 
| ** **                                    | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| **(Dollars in thousands)**          | ** ** | **2008**           | ** ** | **2007**              | ** ** |
|                                          |       |               |       |                  |       |
| Restructured                                  |       | $                  | 347        |                  | $          | 2,335 |   |
| Loans past due  over 90 days still on accrual |       | —             |       | —                |       |
| Non accrual  loans                            |       | 5,211              |       | 6,554                 |       |
| Total                                         |       | $                  | 5,558      |                  | $          | 8,889 |   |

 

**4.****                                     ****EARNINGS PER SHARE**

 

The reconciliation of the numerators and denominators of the basic anddiluted EPS is as follows:

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| **(Dollars in thousands,**            | ** ** | **March 31,**               | ** ** |
| **except per share data)**       | ** ** | **2008**                         | ** ** | **2007** | ** ** |
|                                            |       |                             |       |   |   |
| Net income  available to common shareholders    |       | $                                | 1,883      |   | $ | 2,317 |   |
| Basic EPS:                                      |       |                             |       |   |   |
| Weighted average  common shares                 |       | 4,663                            |       | 4,797 |   |
| Diluted EPS:                                    |       |                             |       |   |   |
| Weighted average  common shares                 |       | 4,663                            |       | 4,797 |   |
| Dilutive effect  of stock options               |       | 35                               |       | 52 |   |
| Weighted average  common and incremental shares |       | 4,698                            |       | 4,849 |   |
| Earnings Per  Share:                            |       |                             |       |   |   |
| Basic                                           |       | $                                | 0.40       |   | $ | 0.48 |   |
| Diluted                                         |       | $                                | 0.40       |   | $ | 0.48 |   |

 

Stock options for 40,600 and 23,100 shares of commonstock were not included in the March 31, 2008 and 2007 computation ofdiluted earnings per share because their impact was anti-dilutive.

 

**5.****                                     ****STOCK OPTION PLAN**

 

Our 2006 Stock Incentive Plan, which is shareholder approved, succeededour 1998 Stock Option and Incentive Plan. Under the 2006 Plan, we may grant either incentive or non-qualifiedstock options to****key employees anddirectors****for a total of 642,350shares of our common stock at not less than fair value at the date such optionsare granted.** **Options available for future grant under the 1998 Plantotaled 38,500 shares and were rolled into the 2006 Plan.** **Webelieve that the ability to award stock options and other forms of stock-basedincentive compensation can assist us in attracting and retaining key employees.Stock-based incentive compensation is also a means  to  align the  interests  of key  employees  with those  of our shareholders  by providing  awards  intended to  reward   recipients for  our  long-term growth.** **The option to purchase shares vestover periods of one to five years and expire ten years after the date of grant.** **Weissue new shares of common stock upon the exercise of stock options. ** **At March 31,2008 options available for future grant under the 2006 Plan totaled 601,750.** **Compensationcost related to options granted under the 1998 and 2006 Plans that was chargedagainst earnings for the periods ended March 31, 2008****and2007 was $28,000 and $26,000.

 

13

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(CONTINUED)**

 

**5.****                                     ****STOCK OPTION PLAN -(Continued)**

 

The fair value of each option award is estimated on the date of grantusing the Black-Scholes option valuation model that uses variousweighted-average assumptions.  Therisk-free interest rate is based on the U.S. Treasury yield curve in effect atthe time of grant.  The expectedvolatility is based on the fluctuation in the price of a share of stock overthe period for which the option is being valued and the expected life of the optionsgranted represents the period of time the options are expected to beoutstanding.

 

Theweighted-average assumptions for options granted during the quarter ended March 31,2008 and the resulting estimated weighted average fair value per share is presentedbelow.

 
| ** **                                     | ** ** | **March 31,** | ** ** |
|------------------------------------------------|------------|--------------------|------------|
| ** **                                     | ** ** | **2008**           | ** ** |
| **Assumptions:**                               |       |               |       |
| Risk-free  interest rate                       |       | 3.52               | %          |
| Expected  dividend yield                       |       | 3.53               | %          |
| Expected life  (years)                         |       | 10                 |       |
| Expected common  stock market price volatility |       | 24                 | %          |
| Estimated fair  value per share                |       | $                  | 4.44       |   |
|                                                |            |                    |            |  |

 

Asummary of option activity under the 1998 and 2006 Plans as of March 31,2008 is presented below:

 
| ** **                           | ** ** | ** **  | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **           | ** ** |
|--------------------------------------|------------|-------------|------------|--------------|------------|-----------------|------------|----------------------|------------|
| ** **                           | ** ** | ** **  | ** ** | **Weighted** | ** ** | **Average**     | ** ** | ** **           | ** ** |
| ** **                           | ** ** | **Number**  | ** ** | **Average**  | ** ** | **Remaining**   | ** ** | **Aggregate**        | ** ** |
| ** **                           | ** ** | **of**      | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic**        | ** ** |
| ** **                           | ** ** | **Options** | ** ** | **Price**    | ** ** | **Term**        | ** ** | **Value**            | ** ** |
| ** **                           | ** ** | ** **  | ** ** | ** **   | ** ** | ** **      | ** ** | **(Dollars In** | ** ** |
| ** **                           | ** ** | ** **  | ** ** | ** **   | ** ** | ** **      | ** ** | **Thousands)**       | ** ** |
| Outstanding,  beginning of period    |       | 193,067     |       | $            | 18.95      | ** **      | ** ** | ** **           | ** ** | ** ** |
| Granted during  period               |       | 5,000       |       | 21.50        | ** ** | ** **      | ** ** | ** **           | ** ** |
| Exercised during  the period         |       | —      |       | —       | ** ** | ** **      | ** ** | ** **           | ** ** |
| Outstanding, end  of period          |       | 198,067     |       | $            | 18.47      |            | 5.4        |                 | $          | 959 |   |
| ** **                           | ** ** | ** **  | ** ** | ** **   | ** ** | ** **      | ** ** | ** **           | ** ** |
| Eligible for  exercise at period end |       | 128,196     |       | $            | 17.10      |            | 4.1        |                 | $          | 866 |   |

 

The total intrinsic value of options exercised during the period ended March 31,2007 was $48,000.  There were no optionsexercised, modified or settled in cash for the period ended March 31,2008.  There was no tax benefitrecognized from the option exercises as they are considered incentive stockoptions.  Management expects alloutstanding unvested options will vest.

 

Asof March 31, 2008 there was $297,000 of total unrecognized compensationcost related to non-vested share-based compensation arrangements granted underthe 1998 and 2006 Plans.  That cost isexpected to be recognized over a weighted-average period of 3.5 years.  Cash received from option exercises under allshare-based payment arrangements for the periods ended March 31, 2008 and2007 was $0 and $57,000.

 

14

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** **

**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(CONTINUED)**

 

**6.****                                     ****FAIR VALUE**

 

SFASNo. 157 defines fair value as the price that would be received to sell anasset or paid to transfer a liability in an orderly transaction between marketparticipants at the measurement date. SFAS No. 157 establishes a fair value hierarchy that prioritizesthe use of inputs used in valuation methodologies into the following threelevels:

 

**Level 1:**Quoted prices (unadjusted) for identical assets or liabilities in active markets.  A quoted price in an active market providesthe most reliable evidence of fair value and shall be used to measure fairvalue whenever available.

 

**Level 2:**Significantother observable inputs other than Level 1 prices such as quoted prices forsimilar assets or liabilities; quoted prices in markets that are not active; orother inputs that are observable or can be corroborated by observable marketdata.

 

**Level 3:**Significant unobservable inputs that reflect a reporting entity’s ownassumptions about the assumptions that market participants would use in pricingan asset or liability.

 

**Assetsand Liabilities Measured at Fair Value on a Recurring Basis**

 

Assetsmeasured at fair value on a recurring basis as of March 31, 2008 aresummarized below:

 
| ** **                     | ** ** | ** **         | ** ** | **Quoted Prices in**   | ** ** | ** **                 | ** ** | ** **                   | ** ** |
|--------------------------------|------------|--------------------|------------|----------------------------------|------------|----------------------------|------------|------------------------------|------------|
| ** **                     | ** ** | ** **         | ** ** | **Active Markets for** | ** ** | **Significant Other** | ** ** | **Significant**              | ** ** |
| ** **                     | ** ** | **March 31,** | ** ** | **Identical Assets**        | ** ** | **Observable Inputs** | ** ** | **Unobservable Inputs** | ** ** |
| **(Dollars in thousands)**     | ** ** | **2008**           | ** ** | **(Level 1)**                    | ** ** | **(Level 2)**              | ** ** | **(Level 3)**                | ** ** |
|                           |       |               |       |                             |       |                       |       |                         |       |
| Assets:                        | ** ** | ** **         | ** ** | ** **                       | ** ** | ** **                 | ** ** | ** **                   | ** ** |
| Available-for-sale  securities |       | $                  | 21,701     |                             | $          | 1,704                      |       | $                            | 17,195     |   | $ | — |   |
|                                |            |                    |            |                                  |            |                            |            |                              |            |  |  |  |  |

 

The fair values of equity securities aredetermined by obtaining quoted prices on nationally recognized securitiesexchanges (Level 1 inputs).  The fairvalues of debt securities are determined by a matrix pricing, which is amathematical technique widely used in the industry to value debt securitieswithout relying exclusively on quoted prices for the specific securities butrather by relying on the securities’ relationship to other benchmark quotedsecurities (Level 2 inputs).  

 

15

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(CONTINUED)**

 

**6.****                                     ****FAIR VALUE - (Continued)**

 

Therewere no transfers in or out of our Level 3 financial assets and liabilities forthe quarter ended March 31, 2008.

 

**Assetsand Liabilities Measured at Fair Value on a Nonrecurring Basis**

 

Assetsmeasured at fair value on a nonrecurring basis as of March 31, 2008 aresummarized below:

** **
| ** **                           | ** ** | ** **         | ** ** | **Quoted Prices in**   | ** ** | ** **                 | ** ** | ** **                   | ** ** |
|--------------------------------------|------------|--------------------|------------|----------------------------------|------------|----------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | ** **         | ** ** | **Active Markets for** | ** ** | **Significant Other** | ** ** | **Significant**              | ** ** |
| ** **                           | ** ** | **March 31,** | ** ** | **Identical Assets**        | ** ** | **Observable Inputs** | ** ** | **Unobservable Inputs** | ** ** |
| **(Dollars in thousands)** | ** ** | **2008**           | ** ** | **(Level 1)**               | ** ** | **(Level 2)**         | ** ** | **(Level 3)**           | ** ** |
|                                 |       |               |       |                             |       |                       |       |                         |       |
| Assets:                              | ** ** | ** **         | ** ** | ** **                       | ** ** | ** **                 | ** ** | ** **                   | ** ** |
| Impaired Loans                       |       | $                  | 5,361      |                             | $          | —                     |       | $                            | —     |   | $ | 5,361 |   |
|                                      |            |                    |            |                                  |            |                            |            |                              |            |  |  |  |  |

 

Impaired loans, which are measured forimpairment using the fair value of the collateral for collateral dependentloans, had a carrying amount of $5.6 million, with a valuation allowance of$197,000, resulting in an additional provision for loan losses of $80,000 forthe 2008 period.  Values for collateraldependent loans are generally based on appraisals obtained from licensed realestate appraisals and in certain circumstances consideration of offers obtainedto purchase properties prior to foreclosure. Appraisals for commercial real estate generally use three methods toderive value: cost, sales or market comparison and income approach.  The cost method bases value in the cost toreplace the current property.  Values ofthe market comparison approach evaluate the sales price of similar propertiesin the same market area.  The incomeapproach considers net operating income generated by the property and aninvestors required return.

 

**7.****                                     ****PENDING ACQUISITION**

 

OnMarch 19, 2008, First Financial Service Corporation issued a press releaseannouncing the signing of a definitive agreement to acquire FSB Bancshares, Inc.and its wholly owned subsidiary, The Farmers State Bank located in SouthernIndiana.  The branches of The FarmersState Bank will become branches of First Financial Service Corporation’s whollyowned subsidiary First Federal Savings Bank. The Farmers State Bank has approximately $63 million in total assets and$52 million in total deposits.  Under theterms of the agreement, FSB Bancshares, Inc. shareholders will receive anaggregate $14.0 million in cash proceeds. The acquisition is expected to be completed during the second quarter of2008.

 

**Item 2.**

 

## **MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**

**AND RESULTSOF OPERATIONS**

##### ** **

##### **GENERAL**

##### ** **

Weconduct operations in 15 full-service banking centers and a commercial privatebanking center in six contiguous counties in Central Kentucky along theInterstate 65 corridor.  Our marketsrange from the major metropolitan area of Louisville in Jefferson County,Kentucky approximately 40 miles north of our headquarters in Elizabethtown,Kentucky to Hart County, Kentucky, approximately 30 miles south ofElizabethtown.  Our markets are supportedby a diversified industry base and have a regional population of over 1million.

 

Weserve the needs and cater to the economic strengths of the local communities inwhich we operate, and we strive to provide a high level of personal andprofessional customer service. We offer a variety of financial services to ourretail and commercial banking customers. These services include personal andcorporate banking services and personal investment financial counselingservices.

 

Through****our personal investment financialcounseling services, we offer a wide variety of mutual funds, equityinvestments, and fixed and variable annuities. We invest in the wholesale capital markets to manage a portfolio

 

16

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ofsecurities and use various forms of wholesale funding. The security portfoliocontains a variety of instruments, including callable debentures, taxable andnon-taxable debentures, fixed and adjustable rate mortgage backed securities,and collateralized mortgage obligations.

 

Ourresults of operations depend primarily on net interest income, which is thedifference between interest income from interest-earning assets and interestexpense on interest-bearing liabilities. Our operations are also affected bynon-interest income, such as service charges, insurance agency revenue, loanfees, gains and losses from the sale of mortgage loans and gains from the saleof real estate held for development. Our principal operating expenses, asidefrom interest expense, consist of compensation and employee benefits, occupancycosts, data processing expense and provisions for loan losses.

 

This discussion and analysis covers material changes in the financialcondition since December 31, 2007 and material changes in the results ofoperations for the three-month period ending, March 31, 2008 as comparedto 2007.  It should be read inconjunction with “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” included in the Annual Report on Form 10-K forthe period ended December 31, 2007.

 

**OVERVIEW**

 

Duringthe first quarter, the Company announced the signing of a definitive agreementto acquire FSB Bancshares, Inc. and its wholly owned subsidiary, TheFarmers State Bank located in Southern Indiana. The Farmers State Bank has approximately $63 million in total assets and$52 million in deposits with offices in Harrison and Floyd County,Indiana.  These counties are adjacent toFirst Financial Service Corporation’s Kentucky counties of Meade andJefferson.  The branches of The FarmersState Bank will become branches of First Financial Service Corporation’s whollyowned subsidiary First Federal Savings Bank. The acquisition is expected to be completed during the second quarter of2008 and is anticipated to be accretive to the Company’s earnings during the firstfull year of the combined operations.

 

Overthe past several years we have focused on enhancing and expanding our retailand commercial banking network in our core markets as well as establishing ourpresence in the Louisville market.  Ourcore markets, where we have a combined 21% market share, have becomeincreasingly competitive as several new banks have entered those markets duringthe past few years.  In order to protectand grow our market share, we replaced existing branches with newer, enhancedfacilities and anticipate constructing several new facilities over the next fewyears.  In addition to the enhancementand expansion in our core markets, we have been increasing our presence in theLouisville market.  Approximately 73% ofthe deposit base in the Louisville market is controlled by six out-of-statebanks.  While the market is verycompetitive, we believe this creates an opportunity for smaller community bankswith more power to make decisions locally. We believe our investment in these initiatives along with our continuedcommitment to a high level of customer service will enhance our market share inour core markets and our development in the Louisville market.

 

Ourretail branch network continues to generate encouraging results.  Total deposits have grown 20% over the pastthree years.  Total deposits were $705.0million at March 31, 2008, an increase of $15.8 million for thequarter.  The continued development ofthe retail branch network into the Louisville market also yielded positive results.  We have a combined $44.3 million in depositsin our three full-service facilities in the Louisville market.  We opened two of these facilities in thesecond quarter of 2004 to support our growing customer base in this market. In June 2007we opened our third new full service banking center in the Louisvillemarket.  Additional sites within theLouisville market are under development with our fourth location scheduled toopen in the second quarter of 2009.

 

Wehave developed a strong commercial real estate niche in our markets.  We have an experienced team of bankers whoare focused on providing service and convenience to our customers.  It is quite common for our bankers to closeloans at a customer’s place of business or even the customer’s personalresidence.   This high level of servicehas been especially well received in our Louisville market, which is dominatedby regional banks.  Currently, 26% of ourloan portfolio resides in the Louisville market.  To further develop our commercial banking relationshipsin Louisville, we opened a private banking office in April 2007.  This office is an upscale facilitycomplementing our retail branch network in Louisville allowing us to furtherattract commercial deposit relationships in conjunction with our commerciallending relationships.

 

Thisemphasis on commercial lending generated 29% growth in the total loan portfolioand 58% growth in commercial loans over the past three years.  Commercial loans were $562.7 million at March 31,2008, an increase of $17.8 million, or 3% for the quarter.

 

17

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###### **CRITICALACCOUNTING POLICIES**

###### ** **

Ouraccounting and reporting policies comply with U.S. generally acceptedaccounting principles and conform to general practices within the bankingindustry.  The accounting policy relatingto the allowance for loan losses is critical to the understanding of ourresults of operations since the application of this policy requires significantmanagement assumptions and estimates that could result in materially differentamounts to be reported if conditions or underlying circumstances were tochange.

 

***Allowance for Loan Losses*****–**We maintain an allowance sufficient to absorbprobable incurred credit losses existing in the loan portfolio. The Allowancefor Loan Loss Review Committee evaluates the allowance for loan losses on aquarterly basis.  We estimate the allowance using past loan lossexperience, known and inherent risks in the portfolio, adverse situations thatmay affect the borrower’s ability to repay, estimated value of the underlyingcollateral, and current economic conditions.  While we estimate theallowance for loan losses based in part on historical losses within each loancategory, estimates for losses within the commercial real estate portfolio aremore dependent upon credit analysis and recent payment performance.Allocations of the allowancemay be made for specific loans or loan categories, but the entire allowance isavailable for any loan that, in management’s judgment, should be charged off.

 

Theallowance consists of specific and general components.  The specific component relates to loans thatare individually classified as impaired or loans otherwise classified assubstandard or doubtful.  The generalcomponent covers non-classified loans and is based on historical lossexperience adjusted for current factors. Allowance estimates are developed withactual loss experience adjusted for current economic conditions.  Allowance estimates are considered a prudentmeasurement of the risk in the loan portfolio and are applied to individualloans based on loan type.

 

Basedon our calculation, an allowance of $8.4 million****or 1.08% of total loans was our estimate of probable losseswithin the loan portfolio as of****March 31,2008.** **This estimate resultedin a provision for loan losses on the income statement of****$584,000 for the quarter.** **If the mix and amount of futurecharge off percentages differ significantly from those assumptions used bymanagement in making its determination, the allowance for loan losses andprovision for loan losses on the income statement could be materiallyincreased.

 

***Stock-based Compensation*****–**We adopted the provisionsof Statement of Financial Accounting Standards (“SFAS”) No. 123 (R) “Share-BasedPayment (Revised 2004),” on January 1, 2006.  Among other things, SFAS No. 123 (R) eliminatesthe ability to account for stock-based compensation using the intrinsic valuebased method of accounting and requires that such transactions be recognized ascompensation expense in the income statement based on their fair values on thedate of the grant.  SFAS No. 123 (R) requiresthat management make assumptions including stock price volatility and employeeturnover that are utilized to measure compensation expense.  We estimate fair value of stock optionsgranted at the date of grant using the Black-Scholes option pricing model,which requires the input of highly subjective assumptions, such as volatility,risk free interest rates and dividend pay out rates.

 

##### **RESULTS OF OPERATIONS**

##### ** **

Net income for the quarter ended March 31, 2008was $1.9 million or $0.40 per share diluted compared to $2.3 million or $0.48per share diluted for the same period in 2007. ** **Earnings decreased for2008 compared to 2007 due to a decrease in our net interest margin, an increasein provision for loan loss expense and a higher level of non-interest expenserelated to our expansion efforts.  ** **Ourbook value per common share increased from $15.10 at March 31, 2007 to$16.01 at March 31, 2008.** **Annualized net income for 2008generated a return on average assets of .87% and a return on average equity of10.16%.** **These compare with a return on average assets of 1.13% and areturn on average equity of 12.99% for the 2007 period also annualized.

 

***Net Interest Income*****–**The principal source of our revenue is netinterest income.  Net interest income isthe difference between interest income on interest-earning assets, such asloans and securities and the interest expense on liabilities used to fund thoseassets, such as interest-bearing deposits and borrowings. Net interest incomeis affected by both changes in the amount and composition of interest-earningassets and interest-bearing liabilities as well as changes in market interestrates.

 

Thegrowth in our commercial loan portfolio has increased interest income.  The increase in the volume of interestearning assets increased net interest income by $169,000 for the quarter ended March 31,2008 compared to the same three-month period a year ago.Average interest earning assets increased$37.1 million for the 2008 period compared to 2007.  Despite the increase in interest earningassets, our net interest margin declined. The yield on earning assets averaged 7.16% for the 2008 period comparedto an average yield on earning assets of

 

18

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7.64%for the same period in 2007.  Thisdecrease was slightly offset by a decrease in our cost of funds.  On an annualized basis, the net interestmargin as a percent of average earning assets decreased****13 basis points to 3.83% for the quarterended March 31, 2008 compared to 3.96% for the 2007 period.

 

Ourcost of funds averaged 3.68% during the 2008 quarter compared to an averagecost of funds of 4.03% for the same period in 2007.** **In March 2007, werefinanced $10.0 million in subordinated debentures.  Refinancing at a lower rate reduced interestexpense by $61,000 for the 2008 quarter. Going forward, our cost of funds is expected to continue to decrease ascertificates of deposit re-price and roll off into new certificates of depositat lower interest rates.

 

Our net interest margin is likely to compress in future quarters as aresult of the 200 basis point decrease by the Federal Open Market Committee(FOMC) since January 2008. Our variable rate loans that are tied to thefederal prime rate immediately re-priced downward with the decrease in rateslowering our yield on loans.  However,interest rates paid on our customer deposits, which are priced off of theLondon Interbank Offering Rate (LIBOR), have not adjusted downward inproportion with the declining interest yields on loans and investments.  This will in turn lower our net interestmargin.

 

19

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**AVERAGE BALANCE SHEET**

 

The following table provides informationrelating to our average balance sheet and reflects the average yield on assetsand average cost of liabilities for the indicated periods.  Yields and costs for the periods presentedare derived by dividing income or expense by the average monthly balance ofassets or liabilities, respectively.

 
| ** **                                           | ** ** | **Quarter Ended March 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                           | ** ** | **2008**                                   | ** ** | **2007** | ** ** |
| ** **                                           | ** ** | **Average**                                | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **(Dollars in thousands)**                 | ** ** | **Balance**                                | ** ** | **Interest** | ** ** | **Yield/Cost (5)** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield/Cost (5)** | ** ** |
|                                                 |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| **ASSETS**                                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest earning  assets:                            |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury  and agencies                          |       | $                                          | 11,283     |   | $ | 106 |   | 3.78 | % | $ | 21,165 |   | $ | 188 |   | 3.60 | % |
| Mortgage-backed  securities                          |       | 10,248                                     |       | 109 |   | 4.28 |   | 13,097 |   | 139 |   | 4.30 |   |
| Equity  securities                                   |       | 1,613                                      |       | 14 |   | 3.49 |   | 2,151 |   | 19 |   | 3.58 |   |
| State and  political subdivision securities (1)      |       | 9,524                                      |       | 152 |   | 6.42 |   | 10,346 |   | 163 |   | 6.39 |   |
| Corporate bonds                                      |       | 3,091                                      |       | 49 |   | 6.38 |   | 5,319 |   | 123 |   | 9.38 |   |
| Loans  (2) (3) (4)                         |       | 774,443                                    |       | 14,032 |   | 7.29 |   | 719,783 |   | 13,941 |   | 7.85 |   |
| FHLB stock                                           |       | 7,622                                      |       | 100 |   | 5.28 |   | 7,621 |   | 120 |   | 6.39 |   |
| Interest bearing  deposits                           |       | 741                                        |       | 6 |   | 3.26 |   | 1,966 |   | 23 |   | 4.74 |   |
| **Total  interest earning assets**                   |       | 818,565                                    |       | 14,568 |   | 7.16 |   | 781,448 |   | 14,716 |   | 7.64 |   |
| Less: Allowance  for loan losses                     |       | (8,060                                     | )          |   |   |   |   | (7,763 | ) |   |   |   |   |
| Non-interest  earning assets                         |       | 64,781                                     |       |   |   |   |   | 60,897 |   |   |   |   |   |
| **Total  assets**                                    |       | $                                          | 875,286    |   |   |   |   |   | $ | 834,582 |   |   |   |   |   |
|                                                 |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**       |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing  liabilities:                       |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Savings accounts                                     |       | $                                          | 95,009     |   | $ | 511 |   | 2.16 | % | $ | 103,242 |   | $ | 861 |   | 3.38 | % |
| NOW and money  market accounts                       |       | 127,211                                    |       | 435 |   | 1.38 |   | 120,752 |   | 478 |   | 1.61 |   |
| Certificates of  deposit and other time deposits     |       | 417,054                                    |       | 4,740 |   | 4.57 |   | 407,338 |   | 4,607 |   | 4.59 |   |
| Short term  borrowings                               |       | 38,634                                     |       | 322 |   | 3.35 |   | 44,278 |   | 575 |   | 5.27 |   |
| FHLB advances                                        |       | 53,061                                     |       | 596 |   | 4.52 |   | 28,195 |   | 336 |   | 4.83 |   |
| Subordinated  debentures                             |       | 10,000                                     |       | 167 |   | 6.72 |   | 10,000 |   | 228 |   | 9.25 |   |
| **Total  interest bearing liabilities**              |       | 740,969                                    |       | 6,771 |   | 3.68 |   | 713,805 |   | 7,085 |   | 4.03 |   |
| Non-interest  bearing liabilities:                   |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest  bearing deposits                       |       | 54,335                                     |       |   |   |   |   | 43,198 |   |   |   |   |   |
| Other  liabilities                                   |       | 5,435                                      |       |   |   |   |   | 5,235 |   |   |   |   |   |
| **Total  liabilities**                               |       | 800,739                                    |       |   |   |   |   | 762,238 |   |   |   |   |   |
|                                                 |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Stockholders’  equity                           |       | 74,547                                     |       |   |   |   |   | 72,344 |   |   |   |   |   |
| **Total  liabilities and stockholders’ equity** |       | $                                          | 875,286    |   |   |   |   |   | $ | 834,582 |   |   |   |   |   |
|                                                 |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| **Net  interest income**                             |       |                                       |       | $ | 7,797 |   |   |   |   |   | $ | 7,631 |   |   |   |
| **Net  interest spread**                             |       |                                       |       |   |   | 3.48 | % |   |   |   |   | 3.61 | % |
| **Net  interest margin**                             |       |                                       |       |   |   | 3.83 | % |   |   |   |   | 3.96 | % |

 

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**(1) **Taxableequivalent yields are calculated assuming a 34% federal income tax rate.

**(2)** Includes loan fees, immaterialin amount, in both interest income and the calculation of yield on loans.

**(3)** Calculations includenon-accruing loans in the average loan amounts outstanding.

**(4)** Includes loans held for sale.

**(5) **Annualized

 

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**RATE/VOLUME ANALYSIS**

 

Thetable below provides information regarding changes in interest income andinterest expense for the indicated periods. For each category of interest-earning assets and interest-bearingliabilities, information is provided on changes attributable to (1) changesin rate (changes in rate multiplied by old volume); (2) changes in volume(change in volume multiplied by old rate); and (3) changes in rate-volume(change in rate multiplied by change in volume).  Changes in rate-volume are proportionatelyallocated between rate and volume variance.

 
| ** **                                       | ** ** | **Three Months Ended  March 31,  2008 vs. 2007**         | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                       | ** ** | **Increase (decrease)  Due to change in** | ** ** |
| ** **                                       | ** ** | ** **                                               | ** ** | ** ** | ** ** | **Net** | ** ** |
| **(Dollars in thousands)**             | ** ** | **Rate**                                                 | ** ** | **Volume** | ** ** | **Change** | ** ** |
| **Interest  income:**                            |       |                                                     |       |   |   |   |   |
| U.S. Treasury  and agencies                      |       | $                                                        | 10         |   | $ | (92 | ) | $ | (82 | ) |
| Mortgage-backed  securities                      |       | —                                                   |       | (30 | ) | (30 | ) |
| Equity  securities                               |       | —                                                   |       | (5 | ) | (5 | ) |
| State and  political subdivision securities      |       | 2                                                        |       | (13 | ) | (11 | ) |
| Corporate bonds                                  |       | (74                                                      | )          | — |   | (74 | ) |
| Loans                                            |       | (931                                                     | )          | 1,022 |   | 91 |   |
| FHLB stock                                       |       | (20                                                      | )          | — |   | (20 | ) |
| Interest bearing  deposits                       |       | (6                                                       | )          | (11 | ) | (17 | ) |
|                                             |       |                                                     |       |   |   |   |   |
| **Total  interest earning assets**               |       | (1,019                                                   | )          | 871 |   | (148 | ) |
|                                             |       |                                                     |       |   |   |   |   |
| **Interest  expense:**                           |       |                                                     |       |   |   |   |   |
| Savings accounts                                 |       | (286                                                     | )          | (64 | ) | (350 | ) |
| NOW and money  market accounts                   |       | (68                                                      | )          | 25 |   | (43 | ) |
| Certificates of  deposit and other time deposits |       | 23                                                       |       | 110 |   | 133 |   |
| Short term  borrowings                           |       | (253                                                     | )          | — |   | (253 | ) |
| FHLB advances                                    |       | (20                                                      | )          | 280 |   | 260 |   |
| Subordinated  debentures                         |       | (61                                                      | )          | — |   | (61 | ) |
|                                             |       |                                                     |       |   |   |   |   |
| **Total  interest bearing liabilities**          |       | (665                                                     | )          | 351 |   | (314 | ) |
|                                             |       |                                                     |       |   |   |   |   |
| **Net  change in net interest income**           |       | $                                                        | (354       | ) | $ | 520 |   | $ | 166 |   |

 

***Non-Interest Income and Non-InterestExpense***

 

Thefollowing tables provide a comparison of the components of non-interest incomeand expenses for the periods ended March 31, 2008 and 2007.  The tables show the dollar and percentagechange from 2007 to 2008.  Below eachtable is a discussion of significant changes and trends.

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                                        | ** ** | **March 31,**               | ** ** | ** ** | ** ** |
| **(Dollars in thousands)**              | ** ** | **2008**                         | ** ** | **2007**   | ** ** | **Change** | ** ** | **%** | ** ** |
| **Non-interest  income**                          | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Customer service  fees on deposit accounts        |       | $                                | 1,416      |       | $          | 1,273 |   | $ | 143 |   | 11.2 | % |
| Gain on sale of  mortgage loans                   |       | 148                              |       | 126        |       | 22 |   | 17.5 | % |
| Gain on sale of  real estate held for development |       | —                           |       | 227        |       | (227 | ) | -100.0 | % |
| Brokerage  commissions                            |       | 118                              |       | 97         |       | 21 |   | 21.6 | % |
| Other income                                      |       | 272                              |       | 222        |       | 50 |   | 22.5 | % |
|                                              |       | $                                | 1,954      |       | $          | 1,945 |   | $ | 9 |   | 0.5 | % |

 

21

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Growthin customer service fees on deposit accounts, our largest component ofnon-interest income, is primarily due to growth in customer deposits, overdraftfee income on retail checking accounts and the sale of fee-based products for2008.  We continue to increase ourcustomer base through cross-selling opportunities and marketing initiatives andpromotions.  In addition, we continue toemphasize growing our checking account base to better enhance our profitabilityand franchise value.

 

We originate qualified VA, KHC, RHC and conventionalsecondary market loans and sell them into the secondary market with servicingrights released.  For the first quarterof 2008, gain on sale of mortgage loans increased due to an increase in thevolume of loans closed, a direct result of the recent rate decreases.

 

Through our subsidiary, First Federal Office Park, we hold commercial lots adjacent to our home office on Ring Road in Elizabethtown, that are available for sale. During the March 2007 quarter we recorded $227,000 in gains from a lot sale.  Currently, one of the original nine lots held for sale remains unsold.

 
| ** **                                                | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                                                | ** ** | **March 31,**               | ** ** | ** ** | ** ** |
| **(Dollars in thousands)**                      | ** ** | **2008**                         | ** ** | **2007**   | ** ** | **Change** | ** ** | **%** | ** ** |
| **Non-interest  expenses**                                | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Employee  compensation and benefits                       |       | $                                | 3,418      |       | $          | 3,124 |   | $ | 294 |   | 9.4 | % |
| Office occupancy  expense and equipment                   |       | 653                              |       | 566        |       | 87 |   | 15.4 | % |
| Marketing and  advertising                                |       | 214                              |       | 271        |       | (57 | ) | -21.0 | % |
| Outside services  and data processing                     |       | 717                              |       | 666        |       | 51 |   | 7.7 | % |
| Bank franchise  tax                                       |       | 250                              |       | 231        |       | 19 |   | 8.2 | % |
| Write off of  issuance cost of Trust Preferred Securities |       | —                           |       | 229        |       | (229 | ) | -100.0 | % |
| Other expense                                             |       | 1,083                            |       | 928        |       | 155 |   | 16.7 | % |
|                                                      |       | $                                | 6,335      |       | $          | 6,015 |   | $ | 320 |   | 5.3 | % |

 

Employeecompensation and benefits is the largest component of non-interestexpense.  Three commercial lendingassociates and twenty-two retail associates have been added with our expansionefforts. These associates were hired for a commercial private banking centerwhich opened in April 2007, a new Louisville retail branch facility thatopened in June 2007, a new Bullitt County retail branch facility to openin July 2008 and other positions to support our growth.  We look for a continued increase in employeecompensation and benefits expense in line with recent years, as we progresswith our retail expansion and market protection efforts.

 

Officeoccupancy expense and equipment and outside services and data processingincreased due to additional operating expenses related to our expansionefforts.  We anticipate the increasedlevel of non-interest expense to continue in 2008 with additional retailexpansion.

 

Included in non-interest expense for the March 2007 quarter is$229,000 in unamortized subordinated debentures issuance cost from theredemption of all of our underlying $10.0 million issuance of cumulative trustpreferred securities.  These securitiespaid distributions at a quarterly adjustable rate of LIBOR plus 360 basispoints (8.97% on March 26, 2007). We obtained new subordinated debentures at a 10 year fixed rate of6.69%.

 

Otherexpense increased due to a new rewards program we created in 2007 to increasedebit card activity.  Expenses related tothis program were $39,000 for the 2008 period. Interchange expense increased $27,000 during the 2008 quarter due toswitching to real-time debit card processing, which is more expensive per itemthan the batch processing method we used previously.

 

Ourefficiency ratio was 65% for the quarter ended March 31, 2008 compared to63% for the 2007 quarter.

 

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**ANALYSIS OF FINANCIAL CONDITION**

 

Totalassets at March 31, 2008 increased to $881.6 million compared to $872.7million at December 31, 2007, an increase of $8.9 million.  The increase was primarily driven by anincrease in loans of $14.4 million.  Thegrowth in loans was funded with deposits, which increased $15.8 million for theperiod.

 

##### **Loans**

##### ** **

Net loans increased $14.4 million to $774.5million at March 31, 2008 compared to $760.1 million at December 31,2007.  Our commercial real estateportfolio increased $22.5 million to $493.4 million at March 31,2008.  For the 2008 period, these loanscomprised 63% of the total loan portfolio compared to 61% at March 31,2007.  Commercial loans remainedrelatively constant for 2008. Offsetting this growth was a $4.7 milliondecrease in the residential mortgage loan portfolio and a $4.0 million decreasein the real estate construction portfolio. Consumer, home equity and indirect consumer loansalso decreased for the 2008 period by $2.3 million to $88.5 million at March 31,2008.  For 2008, the growth in commercialreal estate loans is expected to continue in line with recent periods as wecontinue to emphasize this type of lending.

 
| ** **                           | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|--------------------|------------|-----------------------|------------|
| **(Dollars in thousands)** | ** ** | **2008**           | ** ** | **2007**              | ** ** |
|                                 |       |               |       |                  |       |
| Commercial                           |       | $                  | 51,892     |                  | $          | 52,595 |   |
| Real estate  commercial              |       | 493,385            |       | 470,929               |       |
| Real estate  construction            |       | 17,382             |       | 21,383                |       |
| Residential  mortgage                |       | 127,612            |       | 132,329               |       |
| Consumer and  home equity            |       | 61,654             |       | 63,090                |       |
| Indirect  consumer                   |       | 26,853             |       | 27,721                |       |
| Loans held for  sale                 |       | 4,923              |       | 780                   |       |
|                                 |       | 783,701            |       | 768,827               |       |
| Less:                                | ** ** | ** **         | ** ** | ** **            | ** ** |
| Net deferred  loan origination fees  |       | (810               | )          | (791                  | )          |
| Allowance for  loan losses           |       | (8,395             | )          | (7,922                | )          |
|                                 |       | (9,205             | )          | (8,713                | )          |
| ** **                           | ** ** | ** **         | ** ** | ** **            | ** ** |
| Loans                                |       | $                  | 774,496    |                  | $          | 760,114 |   |

 

**Allowance and Provision for LoanLosses**

 

Our financial performance depends on the quality of the loans weoriginate and management’s ability to assess the degree of risk in existingloans when it determines the allowance for loan losses.  An increase in loan charge-offs ornon-performing loans or an inadequate allowance for loan losses could reducenet interest income, net income and capital and limit the range of products andservices we can offer.

 

The Allowance for Loan Loss Review Committeeevaluates the allowance for loan losses quarterly to maintain a levelsufficient to absorb probable incurred credit losses existing in the loanportfolio.  Periodic provisions to theallowance are made as needed.  Theallowance is determined based on the application of loss estimates to gradedloans by categories.  The amount of theprovision for loan losses necessary to maintain an adequate allowance is alsobased upon an analysis of such factors as changes in lending policies andprocedures; underwriting standards; collection; charge-off and recoveryhistory; changes in national and local economic business conditions anddevelopments; changes in the characteristics of the portfolio; ability anddepth of lending management and staff; changes in the trend of the volume andseverity of past due, non-accrual and classified loans; troubled debtrestructuring and other loan modifications; and results of regulatoryexaminations.

 

23

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The following table provides an analysis of loanloss experience for the periods indicated.

 
| ** **                                                                | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                | ** ** | **March 31,**               | ** ** |
| **(Dollars in thousands)**                                      | ** ** | **2008**                         | ** ** | **2007** | ** ** |
|                                                                      |       |                             |       |   |   |
| **Balance  at beginning of period**                                       |       | $                                | 7,922      |   | $ | 7,684 |   |
| Loans  charged-off:                                                       |       |                             |       |   |   |
| Real estate  mortgage                                                     |       | —                           |       | — |   |
| Consumer                                                                  |       | 128                              |       | 89 |   |
| Commercial                                                                |       | 21                               |       | 17 |   |
| Total  charge-offs                                                        |       | 149                              |       | 106 |   |
| Recoveries:                                                               |       |                             |       |   |   |
| Real estate  mortgage                                                     |       | —                           |       | 8 |   |
| Consumer                                                                  |       | 38                               |       | 62 |   |
| Commercial                                                                |       | —                           |       | 1 |   |
| Total recoveries                                                          |       | 38                               |       | 71 |   |
|                                                                      |       |                             |       |   |   |
| **Net  loans charged-off**                                                |       | 111                              |       | 35 |   |
|                                                                      |       |                             |       |   |   |
| Provision for  loan losses                                                |       | 584                              |       | 81 |   |
|                                                                      |       |                             |       |   |   |
| **Balance  at end of period**                                             |       | $                                | 8,395      |   | $ | 7,730 |   |
|                                                                      |       |                             |       |   |   |
| Allowance for  loan losses to total loans (excluding loans held for sale) |       | 1.08                             | %          | 1.06 | % |
| Annualized net  charge-offs to average loans outstanding                  |       | 0.06                             | %          | 0.02 | % |
| Allowance for  loan losses to total  non-performing loans                 | ** ** | 151                              | %          | 132 | % |

 

Theprovision for loan losses increased $503,000, to $584,000 for the quarter endedMarch 31, 2008, compared to the 2007 period due to growth in the loanportfolio as well as a specific allocation for a loan classified during thefirst quarter of 2008. In addition, we recorded a smaller provision for the2007 period due to the improved performance of one of our credit relationshipswhich resulted in a reduction in the allowance allocated to the loan.  The allowance for loan losses increased$665,000 to $8.4 million from March 31, 2007 to March 31, 2008. ** **Theincrease in the allowance was related to a $14.4 million increase in net loansfor 2008, as well as provision recorded, in conjunction with a $6.6 millionincrease in classified loans for the 2008 period.

 

Federalregulations require banks to classify their own assets on a regular basis.  The regulations provide for three categoriesof classified loans — substandard, doubtful and loss.  A bank must establish general allowances forloan losses for any assets classified as substandard or doubtful. If an assetor portion thereof is classified as loss, the bank must either establishspecified allowances for loan losses in the amount of 100% of the portion ofthe asset classified loss, or charge off the amount of the loss.

 

Thefollowing table provides information with respect to classified loans for theperiods indicated:

** **
| ** **                           | ** ** | **March 31,** | ** ** |
|--------------------------------------|------------|--------------------|------------|
| **(Dollars in thousands)** | ** ** | **2008**           | ** ** | **2007** | ** ** |
| **Classified  Loans**                | ** ** | ** **         | ** ** | ** ** | ** ** |
| Substandard                          |       | $                  | 20,451     |   | $ | 13,913 |   |
| Doubtful                             |       | 63                 |       | 25 |   |
| Loss                                 |       | 18                 |       | 36 |   |
| Total Classified                     |       | $                  | 20,532     |   | $ | 13,974 |   |

 

24

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The$6.5 million increase in substandard assets for 2008 was primarily the result****of the downgrading of loans with fiveborrowers in the amounts of a $4.4 million, $1.8 million, $1.5 million, $1.3million and $792,000,****respectively.** **Offsettingthis increase was the upgrade of a classified loan having a balance of$823,000. Also offsetting this increase was the transfer of two classifiedloans having balances of $1.5 million and $1.1 million to real estate acquiredthrough foreclosure. Approximately $13.3 million of the total classified loanswere related to real estate development or real estate construction loans inour market area.  Classified consumerloans totaled $ 1.2 million, classified mortgage loans totaled $4.1 million andclassified commercial loans totaled $1.9 million.  We remain well secured and adequatelycollateralized with these credits.

 

Althoughwe may allocate a portion of the allowance to specific loans or loancategories, the entire allowance is available for active charge-offs.  We develop our allowance estimates based onactual loss experience adjusted for current economic conditions.  Allowance estimates represent a prudentmeasurement of the risk in the loan portfolio, which we apply to individualloans based on loan type.

 

##### **Non-Performing Assets**

##### ** **

Non-performingassets consist of certain restructured loans for which interest rate or otherterms have been renegotiated, loans on which interest is no longer accrued,real estate acquired through foreclosure and repossessed assets.   We do not have any loans greater than 90days past due still on accrual.  Loans,including impaired loans under SFAS 114, are placed on non-accrual status whenthey become past due 90 days or more as to principal or interest, unless theyare adequately secured and in the process of collection.  Loans are considered impaired when we nolonger anticipate full principal or interest payments in accordance with thecontractual loan terms.  We carryimpaired loans at the present value of expected future cash flows discounted atthe loan’s effective interest rate or at the fair value of the collateral ifthe loan is secured by collateral.

 

Wereview our loans on a regular basis and implement normal collection procedureswhen a borrower fails to make a required payment on a loan.  If the delinquency on a mortgage loan exceeds90 days and is not cured through normal collection procedures or an acceptablearrangement is not worked out with the borrower, we institute measures toremedy the default, including commencing a foreclosure action.  We generally charge off consumer loans whenmanagement deems a loan uncollectible and any available collateral has beenliquidated.  We handle commercialbusiness and real estate loan delinquencies on an individual basis with theadvice of legal counsel.

 

Werecognize interest income on loans on the accrual basis except for those loansin a non-accrual of income status. We discontinue accruing interest on impairedloans when management believes, after consideration of economic and businessconditions and collection efforts that the borrowers’ financial condition issuch that collection of interest is doubtful, typically after the loan becomes90 days delinquent.  When we discontinueinterest accrual, we reverse existing accrued interest and subsequentlyrecognize interest income only to the extent we receive cash payments.

 

We classify real estate acquired as a result offoreclosure or by deed in lieu of foreclosure as real estate owned until suchtime as it is sold. We classify new and used automobile, motorcycle and allterrain vehicles acquired as a result of foreclosure as repossessed assetsuntil they are sold. When such property is acquired we record it at the lowerof the unpaid principal balance of the related loan or its fair marketvalue.  We charge any write-down of theproperty at the time of acquisition to the allowance for loan losses.  Subsequent gains and losses are included innon-interest income and non-interest expense. Real estate acquired through foreclosure increased $1.3 million to $3.0million at March 31, 2008.  Theincrease was the result of a commercial credit relationship totaling $1.1million.

 

25

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Thefollowing table provides information with respect to non-performing assets forthe periods indicated.

 
| ** **                                                                   | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| **(Dollar in thousands)**                                          | ** ** | **2008**           | ** ** | **2007**              | ** ** |
| ** **                                                                   | ** ** | ** **         | ** ** | ** **            | ** ** |
| Restructured                                                                 |       | $                  | 347        |                  | $          | 2,335 |   |
| Past due 90 days  still on accrual                                           |       | —             |       | —                |       |
| Loans on  non-accrual status                                                 |       | 5,211              |       | 6,554                 |       |
|                                                                         |       |               |       |                  |       |
| Total  non-performing loans                                                  |       | 5,558              |       | 8,889                 |       |
| Real estate  acquired through foreclosure                                    |       | 3,021              |       | 1,749                 |       |
| Other  repossessed assets                                                    |       | 74                 |       | 52                    |       |
| Total  non-performing assets                                                 |       | $                  | 8,653      |                  | $          | 10,690 |   |
|                                                                         |       |               |       |                  |       |
| Interest income  that would have been earned on non-performing loans         |       | $                  | 405        |                  | $          | 696 |   |
| Interest income  recognized on non-performing loans                          |       | 144                |       | 188                   |       |
| Ratios:  Non-performing loans to total loans (excluding loans held for sale) |       | 0.71               | %          | 1.16                  | %          |
| Non-performing assets  to total loans (excluding loans held for sale)        |       | 1.11               | %          | 1.39                  | %          |

 

Non-performing loans decreased $3.3 million to$5.6 million at March 31, 2008 compared to $8.9 million at December 31,2007.  The decrease was primarily relatedto a decrease in restructured loans.  Onecredit relationship totaling $2.0 million was removed from the restructuredloan category since the terms of the loan are now substantially equivalent toterms on which loans with comparable risks are being made.  The decrease in non-accrual loans consistprimarily of one credit relationship totaling $1.1 million which wastransferred to real estate acquiredthrough foreclosure. These credit relationships are well secured and no loss isexpected.

 

Non-performing assets for the 2008 period include$347,000 in restructured commercial and consumer loans.** **Therestructured loans primarily consist of two credit relationships with balancesof $194,000 and $97,000.   The terms ofthese loans have been renegotiated to reduce the rate of interest and extendthe term, thus reducing the amount of cash flow required from the borrower toservice the loans. The borrowers are currently meeting the terms of therestructured loans.

 

**Investment Securities**

 

Intereston securities provides us our largest source of interest income after intereston loans, constituting 3.3% of the total interest income for the quarter ended March 31,2008.  Thesecurities portfolio serves as a source of liquidity and earnings andcontributes to the management of interest rate risk.  We have the authority to invest invarious types of liquid assets, including short-term United States Treasuryobligations and securities of various federal agencies, obligations of statesand political subdivisions, corporate bonds, certificates of deposit at insuredsavings and loans and banks, bankers’ acceptances, and federal funds.  We may also invest a portion of our assets incertain commercial paper and corporate debt securities.  We are also authorized to invest in mutualfunds and stocks whose assets conform to the investments that we are authorizedto make directly. The available-for-sale and held-to-maturity investmentportfolios decreased by $11.6 million during the 2008 period as securities werecalled for redemption in accordance with their terms due to decreasingrates.  During the March 2008 periodwe did not purchase any new investment securities.

 

All unrealized losses arereviewed at least on a quarterly basis to determine whether the losses areother than temporary and more frequently when economic or market concernswarrant such evaluation. Consideration is given to the length of time and theextent to which the fair value has been less than cost, the financial conditionand near-term prospects of the issuer, and our intent and ability to retain theinvestment in the issuer for a period of time sufficient to allow for anyanticipated recovery in fair value.  Inanalyzing an issuer’s financial condition, we may consider whether thesecurities are issued by the federal government or its agencies, whetherdowngrades by bond rating agencies have occurred, and the results of reviews ofthe issuer’s financial condition.

 

The unrealized losses on ourtemporarily impaired debt securities are a result of changes in interest ratesfor fixed-rate securities where the interest rate received is less than thecurrent rate available for new offerings of

 

26

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similar securities.   Because the decline in market value isattributable to changes in interest rates and not credit quality, and becausewe have the ability and intent to hold these investments until recovery of fairvalue, which may be maturity, we do not consider these investments to beother-than-temporarily impaired at March 31, 2008.

 

###### **Deposits**

###### ** **

Werely primarily on customer service and long-standing relationships withcustomers to attract and retain deposits. Market interest rates and rates ondeposit products offered by competing financial institutions can significantlyaffect our ability to attract and retain deposits.  In conjunction with our initiatives to expandand enhance our retail branch network, we emphasize growing our customerchecking account base to better enhance profitability and franchise value.  During the quarter ended March 31, 2008,total deposits increased by $15.8 million compared to December 31, 2007.Retail and commercial deposits increased $6.4 million and we added $9.4 millionin public funds and brokered certificates for the quarter.

 

Thefollowing table breaks down our deposits.

 
| ** **               | ** ** | **March 31,**      | ** ** | **December 31,** | ** ** |
|--------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **2008**                | ** ** | **2007**              | ** ** |
| ** **               | ** ** | **(In Thousands)** | ** ** |
|                     |       |                    |       |                  |       |
| Non-interest  bearing    |       | $                       | 58,062     |                  | $          | 46,978 |   |
| NOW demand               |       | 85,691                  |       | 79,133                |       |
| Savings                  |       | 109,020                 |       | 91,249                |       |
| Money market             |       | 48,897                  |       | 49,306                |       |
| Certificates of  deposit |       | 403,335                 |       | 422,577               |       |
|                     |       | $                       | 705,005    |                  | $          | 689,243 |   |

 

**Short-Term Borrowings**

 

We have the ability to obtain short-term borrowings,consisting of federal funds purchased and securities sold under agreements torepurchase.  We had short-term borrowingsof $34.4 million and $32.7 million from the FHLB of Cincinnati at March 31,2008 and 2007.  These borrowings averageda rate of 3.35% and 5.27% for 2008 and 2007.

 

**Advances from Federal Home Loan Bank**

 

Deposits are the primary source of funds forour lending and investment activities and for our general businesspurposes.  We can also use advances(borrowings) from the Federal Home Loan Bank (FHLB) of Cincinnati to compensatefor reductions in deposits or deposit inflows at less than projectedlevels.  Advances from the FHLB aresecured by our stock in the FHLB, certain securities, certain commercial realestate loans and substantially all of our first mortgage, multi-family and openend home equity loans.  At March 31,2008 we had $53.0 million in advances outstanding from the FHLB and thecapacity to increase our borrowings an additional $29.5 million.

 

**Subordinated Debentures**

 

We have $10.0 million inoutstanding subordinated debentures.  Atrust we formed completed a private placement of 10,000 shares of cumulativetrust preferred securities with a liquidation preference of $1,000 per securityfor a total outstanding of $10.0 million. The proceeds of the offering were loaned to us in exchange for juniorsubordinated deferrable interest debentures. In accordance with FASB Interpretation46, the trust is not consolidated with our financial statements but rather thesubordinated debentures are shown as a liability.  These securities pay distributions ofinterest. On March 26, 2007 we called the $10.0 million in subordinateddebentures adjustable quarterly at LIBOR plus 360 basis points (8.97% on March 26,2007) and issued new 30 year cumulative trust preferred securities at a 10 yearfixed rate of 6.69% adjusting quarterly thereafter at LIBOR plus 160 basispoints.  The subordinated debentures,which mature March 22, 2037, can be called at par in whole or in part onor after March 15, 2017.  We havethe option to defer interest payments on the subordinated debt from time totime for a period not to exceed five consecutive years. The subordinateddebentures are considered as Tier I capital for the Corporation under currentregulatory guidelines.

 

27

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##### **LIQUIDITY**

##### ** **

Liquidity risk arises from the possibility we may not be able to satisfy current or future financial commitments, or may become unduly reliant on alternative funding sources. The objective of liquidity risk management is to ensure that we can meet the cash flow requirements of depositors and borrowers, as well as our operating cash needs, at a reasonable cost, taking into account all on- and off-balance sheet funding demands. We maintain an investment and funds management policy, which identifies the primary sources of liquidity, establishes procedures for monitoring and measuring liquidity, and establishes minimum liquidity requirements in compliance with regulatory guidance. The Asset Liability Committee continually monitors our liquidity position.

 

Our sources of funds include the sale of securities in the available-for-sale portion of the investment portfolio, principal pay-downs on loans and mortgage-backed securities, proceeds realized from loans held for sale, brokered deposits and other wholesale funding.  We also secured federal funds borrowing lines from two of our correspondent banks of $15 million each.  Our banking centers also provide access to retail deposit markets.  If large certificate depositors shift to our competitors or other markets in response to interest rate changes, we have the ability to replenish those deposits through alternative funding sources.  Traditionally, we have also borrowed from the FHLB to supplement our funding requirements.  At March 31, 2008, we had an unused approved line of credit in the amount of $100.6 million and sufficient collateral available to borrow, approximately, an additional $29.5 million in advances from the FHLB.**** We believe our sources of liquidity are adequate to meet expected cash needs for the foreseeable future.

 

At the holding company level, the Corporation uses cash to pay dividends to stockholders, repurchase common stock, make selected investments and acquisitions, and service debt. The main sources of funding for the Corporation include dividends from the Bank, borrowings and access to the capital markets.

 

###### **The primary source offunding for the Corporation has been dividends and returns of investment fromthe Bank. Kentucky banking laws limit the amount of dividends that may be paidto the Corporation by the Bank without prior approval of the KOFI.  Under these laws, the amount of dividendsthat may be paid in any calendar year is limited to current year’s net income,as defined in the laws, combined with the retained net income of the precedingtwo years, less any dividends declared during those periods.  At March 31, 2008, the Bank hadapproximately $10.3 million of retained earnings that could be used to paydividends without prior regulatory approval. Because of these limitations, consolidated cash flows as presented inthe consolidated statements of cash flows may not represent cash immediatelyavailable to the Corporation.  During2008, the Bank declared and paid dividends of $1.1 million to the Corporation.**

###### ** **

##### **CAPITAL**

##### ** **

Stockholders’ equityincreased $1.2 million for the period ended March 31, 2008 compared to December 31,2007 primarily due to net income earned during the quarter.  This increase was offset by cash dividendsdeclared during the period.  Averagestockholders’ equity to average assets ratio decreased to 8.52% for the quarterended March 31, 2008 compared to 8.67% for 2007.

 

During the first quarter of 2008, we did not purchase any shares of ourown common stock.  The current repurchase program authorizes therepurchase of 398,601 shares from time-to-time if market conditions are deemedfavorable.  The repurchase program will remain effectiveuntil the number of shares authorized is repurchased or until the programexpires September 19, 2008.  As of March 31, 2008, 242,560 sharescould be repurchased under the current stock repurchase program.

 

Each of the federal bank regulatory agencies hasestablished minimum leverage capital requirements for banks. Banks mustmaintain a minimum ratio of Tier 1 capital to adjusted average quarterly assetsranging from 3% to 5%, subject to federal bank regulatory evaluation of anorganization’s overall safety and soundness. We intend to maintain a capital position that meets or exceeds the “wellcapitalized” requirements as defined for banks by the FDIC.  The following table shows the ratios of Tier1 capital and total capital to risk-adjusted assets and the leverage ratios forthe Corporation and the Bank as of March 31, 2008.

 

28

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| ** **                                           | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Considered  Well Capitalized  Under Prompt  Correction  Action Provisions** | ** ** |
|------------------------------------------------------|------------|------------|------------|----------------------------------------------|------------|------------------------------------------------------------------------------------------|------------|
| **(Dollars in thousands)**                 | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                               | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **As of  March 31, 2008:**                           |       |       |       |                                         |       |                                                                                     |       |   |   |   |   |   |   |
| Total risk-based  capital (to risk- weighted assets) |       |       |       |                                         |       |                                                                                     |       |   |   |   |   |   |   |
| Consolidated                                         |       | $          | 84,952     |                                         | 10.8       | %                                                                                        | $          | 62,901 |   | 8.0 | % | N/A |   | N/A |   |
| Bank                                                 |       | 81,573     |       | 10.4                                         |       | 62,694                                                                                   |       | 8.0 |   | $ | 78,368 |   | 10 | % |
| Tier I capital  (to risk-weighted assets)            | ** ** | ** ** | ** ** | ** **                                   | ** ** | ** **                                                                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Consolidated                                         |       | 76,489     |       | 9.7                                          |       | 31,450                                                                                   |       | 4.0 |   | N/A |   | N/A |   |
| Bank                                                 |       | 73,084     |       | 9.3                                          |       | 31,347                                                                                   |       | 4.0 |   | 47,021 |   | 6 | % |
| Tier I capital  (to average assets)                  | ** ** | ** ** | ** ** | ** **                                   | ** ** | ** **                                                                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Consolidated                                         |       | 76,489     |       | 8.8                                          |       | 34,676                                                                                   |       | 4.0 |   | N/A |   | N/A |   |
| Bank                                                 |       | 73,084     |       | 8.4                                          |       | 34,688                                                                                   |       | 4.0 |   | 43,360 |   | 5 | % |
|                                                 |       |       |       |                                         |       |                                                                                     |       |   |   |   |   |   |   |
| ** **                                           | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes**           | ** ** | **To Be Considered  Well Capitalized  Under Prompt  Correction  Action Provisions**      | ** ** |
| **(Dollars in thousands)**                           | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                               | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **As of  December 31, 2007:**                   |       |       |       |                                         |       |                                                                                     |       |   |   |   |   |   |   |
| Total risk-based  capital (to risk- weighted assets) |       |       |       |                                         |       |                                                                                     |       |   |   |   |   |   |   |
| Consolidated                                         |       | $          | 83,310     |                                         | 10.9       | %                                                                                        | $          | 61,405 |   | 8.0 | % | N/A |   | N/A |   |
| Bank                                                 |       | 80,176     |       | 10.5                                         |       | 61,220                                                                                   |       | 8.0 |   | $ | 76,526 |   | 10.0 |   |
| Tier I capital  (to risk-weighted assets)            | ** ** | ** ** | ** ** | ** **                                   | ** ** | ** **                                                                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Consolidated                                         |       | 75,388     |       | 9.8                                          |       | 30,703                                                                                   |       | 4.0 |   | N/A |   | N/A |   |
| Bank                                                 |       | 72,126     |       | 9.4                                          |       | 30,610                                                                                   |       | 4.0 |   | 45,915 |   | 6.0 |   |
| Tier I capital  (to average assets)                  | ** ** | ** ** | ** ** | ** **                                   | ** ** | ** **                                                                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Consolidated                                         |       | 75,388     |       | 8.7                                          |       | 34,661                                                                                   |       | 4.0 |   | N/A |   | N/A |   |
| Bank                                                 |       | 72,126     |       | 8.3                                          |       | 34,661                                                                                   |       | 4.0 |   | 43,326 |   | 5.0 |   |

 

###### **Item 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

###### ** **

###### **Asset/Liability Managementand Market Risk**

###### ** **

To minimize the volatility of net interest incomeand exposure to economic loss that may result from fluctuating interest rates,we manage our exposure to adverse changes in interest rates through asset andliability management activities within guidelines established by our AssetLiability Committee (“ALCO”).  The ALCO,which includes senior management representatives, has the responsibility forapproving and ensuring compliance with asset/liability management polices.  Interest rate risk is the exposure to adversechanges in the net interest income as a result of market fluctuations ininterest rates.  The ALCO, on an ongoingbasis, monitors interest rate and liquidity risk in order to implementappropriate funding and balance sheet strategies.  Management considers interest rate risk to beour most significant market risk.

 

Weutilize an earnings simulation model to analyze net interest incomesensitivity.  We then evaluate potentialchanges in market interest rates and their subsequent effects on net interestincome.  The model projects the effect ofinstantaneous movements in interest rates of both 100 and 200 basispoints.  We also incorporate assumptionsbased on the historical behavior of our deposit rates and balances in relationto changes in interest rates into the model. These assumptions are inherently uncertain and, as a result, the modelcannot precisely measure future net interest income or precisely predict theimpact of fluctuations in market interest rates on net interest income.  Actual results will differ from the model’ssimulated results due to timing, magnitude and frequency of interest ratechanges as well as changes in market conditions and the application and timingof various management strategies.

 

29

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Ourinterest sensitivity profile was asset sensitive at March 31, 2008 and December 31,2007.  Given a sustained 100 basis pointdecrease in rates, our base net interest income would decrease by an estimated****.26% at March 31, 2008 compared to adecrease of 1.10% at December 31, 2007. ** **Given a 100 basis point increase ininterest rates our base net interest income would increase by an****estimated .48% at March 31, 2008compared to an increase of 1.09% at December 31, 2007.

 

Ourinterest sensitivity at any point in time will be affected by a number offactors.  These factors include the mixof interest sensitive assets and liabilities, their relative pricing schedules,market interest rates, deposit growth, loan growth, decay rates and prepaymentspeed assumptions.

 

Weuse various asset/liability strategies to manage the re-pricing characteristicsof our assets and liabilities designed to ensure that exposure to interest ratefluctuations is limited within our guidelines of acceptable levels ofrisk-taking.  As demonstrated by the March 31,2008 and December 31, 2007 sensitivity tables, our balance sheet has anasset sensitive position. This means that our earning assets, which consist ofloans and investment securities, will change in price at a faster rate than ourdeposits and borrowings.  Therefore, ifshort term interest rates increase, our net interest income will be favorablyimpacted.  Likewise, if short terminterest rates decrease, our net interest income will be negatively impacted.

 

FromSeptember 2007 through March 2008, the Federal Open Market Committeehas decreased short-term interest rates 300 basis points.  If short-term interest rates decline, our netinterest margin and the level of net interest income would also decrease.** **Wecontinually monitor the effects rate changes will have on our level of netinterest income, and management works to structure the maturity and pricing ofloans and deposits to mitigate large swings in net interest income.  During 2007, we made efforts to increase thelevel of short-term deposits offering more attractive rates on short-termcertificates of deposits.  In March 2007,we called our $10.0 million in subordinated debentures adjustable quarterly atLIBOR plus 360 basis points (8.97% on March 26, 2007) and we re-issued new30 year cumulative trust preferred securities at a 10 year fixed rate of 6.69%adjusting quarterly thereafter at LIBOR plus 160 basis points.  In addition, the majority of the newlyoriginated or renewed loans during 2008 and 2007 were fixed rates loans withthe interest rate fixed from three to five years.

 

30

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Oursensitivity to interest rate changes is presented based on data as of March 31,2008 and December 31, 2007 annualized to a one year period.

 
| ** **                           | ** ** | **March 31, 2008**    | ** ** |
|--------------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **Decrease in Rates** | ** ** | ** ** | ** ** | **Increase in Rates** | ** ** |
| ** **                           | ** ** | **200**                         | ** ** | **100** | ** ** | ** ** | ** ** | **100** | ** ** | **200** | ** ** |
| **(Dollars in thousands)** | ** ** | **Basis Points**           | ** ** | **Basis Points** | ** ** | **Base** | ** ** | **Basis Points** | ** ** | **Basis Points** | ** ** |
|                                 |       |                            |       |   |   |   |   |   |   |   |   |
| **Projected  interest income**       |       |                            |       |   |   |   |   |   |   |   |   |
| Loans                                |       | $                               | 48,635     |   | $ | 50,088 |   | $ | 51,459 |   | $ | 52,889 |   | $ | 54,271 |   |
| Investments                          |       | 1,244                           |       | 1,277 |   | 1,301 |   | 1,330 |   | 1,359 |   |
| **Total  interest income**           |       | 49,879                          |       | 51,365 |   | 52,760 |   | 54,219 |   | 55,630 |   |
|                                 |       |                            |       |   |   |   |   |   |   |   |   |
| **Projected  interest expense**      |       |                            |       |   |   |   |   |   |   |   |   |
| Deposits                             |       | 15,162                          |       | 16,039 |   | 16,998 |   | 17,944 |   | 18,929 |   |
| Borrowed funds                       |       | 888                             |       | 1,240 |   | 1,588 |   | 1,937 |   | 2,286 |   |
| **Total  interest expense**          |       | 16,050                          |       | 17,279 |   | 18,586 |   | 19,881 |   | 21,215 |   |
|                                 |       |                            |       |   |   |   |   |   |   |   |   |
| **Net  interest income**             |       | $                               | 33,829     |   | $ | 34,086 |   | $ | 34,174 |   | $ | 34,338 |   | $ | 34,415 |   |
| Change from base                     |       | $                               | (345       | ) | $ | (88 | ) |   |   | $ | 164 |   | $ | 241 |   |
| % Change from  base                  |       | (1.01                           | )%         | (.26 | )% |   |   | .48 | % | .71 | % |

 
| ** **                           | ** ** | **December 31, 2007** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **Decrease in Rates** | ** ** | ** ** | ** ** | **Increase in Rates** | ** ** |
| ** **                           | ** ** | **200**                         | ** ** | **100** | ** ** | ** ** | ** ** | **100** | ** ** | **200** | ** ** |
| **(Dollars in thousands)** | ** ** | **Basis Points**           | ** ** | **Basis Points** | ** ** | **Base** | ** ** | **Basis Points** | ** ** | **Basis Points** | ** ** |
|                                 |       |                            |       |   |   |   |   |   |   |   |   |
| **Projected  interest income**       |       |                            |       |   |   |   |   |   |   |   |   |
| Loans                                |       | $                               | 54,208     |   | $ | 55,624 |   | $ | 57,011 |   | $ | 58,344 |   | $ | 59,644 |   |
| Investments                          |       | 2,319                           |       | 2,351 |   | 2,376 |   | 2,407 |   | 2,439 |   |
| **Total  interest income**           |       | 56,527                          |       | 57,975 |   | 59,387 |   | 60,751 |   | 62,083 |   |
| ** **                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Projected  interest expense**      | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deposits                             |       | 20,995                          |       | 21,856 |   | 22,733 |   | 23,572 |   | 24,485 |   |
| Borrowed funds                       |       | 3,481                           |       | 3,656 |   | 3,829 |   | 3,997 |   | 4,166 |   |
| **Total  interest expense**          |       | 24,476                          |       | 25,512 |   | 26,562 |   | 27,569 |   | 28,651 |   |
| ** **                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net  interest income**             |       | $                               | 32,051     |   | $ | 32,463 |   | $ | 32,825 |   | $ | 33,182 |   | $ | 33,432 |   |
| Change from base                     |       | $                               | (774       | ) | $ | (362 | ) |   |   | $ | 357 |   | $ | 607 |   |
| % Change from  base                  |       | (2.36                           | )%         | (1.10 | )% |   |   | 1.09 | % | 1.85 | % |

 

###### **Item 4.  CONTROLS AND PROCEDURES**

###### ** **

*Evaluation of disclosure controls and procedures*

 

Ourmanagement, with the participation of our Chief Executive Officer and our ChiefFinancial Officer, evaluated the effectiveness of our disclosure controls andprocedures as of the end of the period covered by this quarterly report on Form 10-Q.Based on this evaluation, our Chief Executive Officer and our Chief FinancialOfficer have concluded that our disclosure controls and procedures wereeffective as of the end of the period covered by this Quarterly Report on Form 10-Qto ensure that information we are required to disclose in reports that we fileor submit under the Securities Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in Securities andExchange Commission rules and forms.

 

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*Limitations on the Effectiveness of Controls*

 

A control system, no matter how well designed andoperated, can provide only reasonable, not absolute, assurance that the controlsystem’s objectives will be met. Further, the design of a control system must reflect the fact that thereare resource constraints, and the benefits of controls must be consideredrelative to their costs.  Because of theinherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, with our company have been detected. These inherent limitations include the realities that judgments indecision making can be faulty, that breakdowns can occur because of simpleerrors or mistakes, and that controls can be circumvented by the acts ofindividuals or groups.  Because of theinherent limitations in a cost effective control system, misstatements due toerror or fraud may occur and not be detected.

 

*Changes in internal control over financial reporting*

 

Therewas no change in our internal control over financial reporting that occurredduring the period covered by this quarterly report on Form 10-Q that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

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##### **Part II - OTHERINFORMATION**

##### ** **

**Item 1.****           ****LegalProceedings**

 

Although, from time to time, we are involved in variouslegal proceedings in the normal course of business, there are no materialpending legal proceedings to which we are a party, or to which any of ourproperty is subject.

 

**Item 1A.****        ****RiskFactors**

 

We did not have any changes to our risk factorspreviously disclosed in our Annual Report on Form 10-K for the year ended December 31,2007.

 

**Item 2.****           ****UnregisteredSales of Securities and Use of Proceeds**

 

(e)  Issuer Purchasesof Equity Securities

 

We did not repurchase any shares of our common stock during the quarter ended March 31, 2008.

 

**Item 3.****           ****DefaultsUpon Senior Securities**

 

Not Applicable

 

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

 

Not Applicable

 

###### **Item5.**            OtherInformation

###### ** **

None

 

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

 
| 31.1   |   | Certification of Chief Executive Officer Pursuant  to Section 302 of Sarbanes-Oxley Act                                                                                                            |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                    |
| 31.2   |   | Certification of Chief Financial Officer Pursuant  to Section 302 of Sarbanes-Oxley Act                                                                                                            |
|   |   |                                                                                                                                                                                                    |
| 32     |   | Certification of Chief Executive Officer and Chief  Financial Officer Pursuant to Section 18 U.S.C. Section 1350 (As  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) |

 

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**FIRST FINANCIAL SERVICE CORPORATION**

 

## **SIGNATURES**

## ** **

Pursuant to the requirements of Section 13 or15(d) of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 

 
| Date: May 12, 2008 | By:  /s/ | B. Keith Johnson                   |
|-------------------------|--------------------|------------------------------------|
|                    |               |  B. Keith Johnson             |
|                    |               |  Chief Executive Officer      |
|                    |               |                               |
|                    |               |                               |
| Date: May 12, 2008 | By:  /s/ | Steven M. Zagar                    |
|                    |               | Steven M. Zagar                    |
|                    |               | Chief Financial Officer & |
|                    |               | Principal Accounting Officer       |

 

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## **INDEX TO EXHIBITS**

## ** **

| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                             |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                                                        |
| 31.1                 |       | Certification  of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act                                                                                                |
|                 |       |                                                                                                                                                                                        |
| 31.2                 |       | Certification  of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act                                                                                                |
|                 |       |                                                                                                                                                                                        |
| 32                   |       | Certification  of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C.  Section 1350 (As Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002) |

 

35

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