United
States
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C.   20549
 ________________________________________________________
 
 FORM
10-Q
 
 ý     QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d)
 OF
THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period
ended June 30, 2008
 OR
  ̈      TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d)
 OF
THE SECURITIES EXCHANGE ACT OF 1934
 For the
transition period from _________  to __________
 _________________________________________________________
 
 NORTHERN
STATES FINANCIAL CORPORATION
 (Exact
name of Registrant as specified in its charter)
 
 Delaware
                0-19300
                36-3449727(State
      of Incorporation)
                (Commission
                (I.R.S.
      EmployerFile
      Number)
                Identification
      No.)
 1601
North Lewis Avenue
 Waukegan,
Illinois  60085
 (847)
244-6000
 (Address,
including zip code, and telephone number, including
 area
code, of principal executive office)
 _________________________________________________________
 
 Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for shorter period that the registrant was required to
file such reports) and (2) has been subject to such filing requirements for the
past 90 days.        YES: ý             NO:
 ̈
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See definitions of “large accelerated filer”, “accelerated
filer” and “smaller reporting company” in Rule 12b-2 of the Exchange
Act.  (Check one):
 Large
Accelerated Filer  ̈    Accelerated
Filer ý    Non-accelerated
Filer  ̈    Smaller
reporting company  ̈
 
 Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). YES:   ̈         NO:  ý
 
 4,072,255
shares of common stock were outstanding
 at August
4, 2008
 
 
 
 NORTHERN STATES FINANCIAL
CORPORATION AND SUBSIDIARY
 FORM
10-Q
 For the Quarter Ended June
30, 2008
 INDEX
 
 
 
 Page
      NumberPART
      I.
              FINANCIAL INFORMATIONItem 1.
              Financial StatementsReport of  Independent Registered Public
      Accounting Firm.
              2Condensed Consolidated Financial Statements and
      Notes
              3Item 2.
              Management’s Discussion and Analysis of Financial
      Condition and Results of Operations
              9Item 3.
              Quantitative and Qualitative Disclosures About Market
      Risk
              22Item 4.
              Controls and Procedures
              24PART II.
              OTHER INFORMATIONItem
      1.
              Legal Proceedings
              24Item 1A.
              Risk Factors
              24Item 2.
              Unregistered Sales of Equity Securities and Use of
      Proceeds
              25Item 3.
              Defaults upon Senior Securities
              26Item 4.
              Submission of Matters to a Vote of Security
      Holders
              26Item 5.
              Other
      Information
              26Item 6.
              Exhibits
              27Signatures
              
              28EXHIBIT INDEX
              
              29
 
  1
 Table of Contents
 
  PART I.FINANCIAL INFORMATION
 
 ITEM 1.
FINANCIAL STATEMENTS
 
 
 
 
 
 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM
 
 
 Board of
Directors and Stockholders
 Northern
States Financial Corporation
 Waukegan,
Illinois
 
 We have
reviewed the accompanying interim condensed consolidated balance sheet of
NORTHERN STATES FINANCIAL CORPORATION as of June 30, 2008, the condensed
consolidated statements of income for the three and six month periods ended June
30, 2008 and 2007 and the condensed statements of cash flows and stockholders
equity for the six month periods ended June 30, 2008 and 2007.  These
interim financial statements are the responsibility of the company's
management.
 
 We
conducted our review in accordance with standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with the
standards of the Public Company Accounting Oversight Board, the objective of
which is the expression of an opinion regarding the financial statements taken
as a whole. Accordingly, we do not express such an opinion.
 
 Based on
our review, we are not aware of any material modifications that should be made
to the accompanying interim condensed financial statements for them to be in
conformity with accounting principles generally accepted in the United States of
America.


/s/Plante
      & Moran, PLLCChicago,
      IllinoisJuly
      31, 2008
   2
 Table of Contents




NORTHERN STATES FINANCIAL
CORPORATION
 CONDENSED CONSOLIDATED BALANCE SHEETS
 June 30,
2008 and December 31, 2007
 (In
thousands of dollars) (Unaudited)
  June
      30,
              
              
              December
      31,Assets
              
              2008
              
              
              2007Cash
      and due from banks
              
              $
              14,806
              
              
              $
              14,273Interest
      bearing deposits in financial institutions -maturities less
      than 90 days
              
              
              129
              
              
              
              180Federal
      funds sold
              
              
              0
              
              
              
              9,181Total
      cash and cash equivalents
              
              
              14,935
              
              
              
              23,634Securities
      available for sale
              
              
              123,243
              
              
              
              153,277Loans
      and leases
              
              
              476,305
              
              
              
              435,734Less:
      Allowance for loan and lease losses
              
              
              (7,561
              )
              
              
              (4,606
              )Loans
      and leases, net
              
              
              468,744
              
              
              
              431,128Federal
      Home Loan Bank stock
              
              
              1,757
              
              
              
              1,445Office
      buildings and equipment, net
              
              
              9,579
              
              
              
              9,198Other
      real estate owned
              
              
              2,857
              
              
              
              2,857Goodwill
              
              
              9,522
              
              
              
              9,522Core
      deposit intangible asset
              
              
              1,158
              
              
              
              1,390Accrued
      interest receivable and other assets
              
              
              7,839
              
              
              
              5,705Total
      assets
              
              $
              639,634
              
              
              $
              638,156Liabilities
      and Stockholders' EquityLiabilitiesDepositsDemand
      - noninterest bearing
              
              $
              57,351
              
              
              $
              60,015Interest
      bearing
              
              
              410,767
              
              
              
              420,944Total
      deposits
              
              
              468,118
              
              
              
              480,959Securities
      sold under repurchase agreements
              
              
              49,095
              
              
              
              66,797Federal
      Home Loan Bank advances
              
              
              25,000
              
              
              
              0Federal
      funds purchased
              
              
              13,100
              
              
              
              0Subordinated
      debentures
              
              
              10,000
              
              
              
              10,000Advances
      from borrowers for taxes and insurance
              
              
              1,031
              
              
              
              1,066Accrued
      interest payable and other liabilities
              
              
              4,584
              
              
              
              5,880Total
      liabilities
              
              
              570,928
              
              
              
              564,702Stockholders'
      EquityCommon
      stock (Par value $.40 per share, 6,500,000 authorized,4,472,255
      shares issued at June 30, 2008 and December 31, 2007)
              
              
              1,789
              
              
              
              1,789Additional
      paid-in capital
              
              
              11,584
              
              
              
              11,584Retained
      earnings
              
              
              66,406
              
              
              
              66,983Treasury
      stock, at cost (400,000 shares at June 30, 2008and 294,150 at
      December 31, 2007)
              
              
              (9,280
              )
              
              
              (7,202
              )Accumulated
      other comprehensive income(loss)
              
              
              (1,793
              )
              
              
              300Total
      stockholders' equity
              
              
              68,706
              
              
              
              73,454Total
      liabilities and stockholders' equity
              
              $
              639,634
              
              
              $
              638,156
  The
accompanying notes are an integral part of these condensed consolidated
financial statements.
  3
 Table of Contents
 NORTHERN STATES FINANCIAL
CORPORATION
 CONDENSED CONSOLIDATED
STATEMENTS OF INCOME
 Three and
six months ended June 30, 2008 and 2007
 (In
thousands of dollars, except per share data) (Unaudited)
 
 Three
      months ended
              
              
              Six
      months endedJune
      30,
              
              
              June
      30,
              
              
              June
      30,
              
              
              June
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007Interest
      incomeLoans
      (including fee income)
              
              $
              7,052
              
              
              $
              6,813
              
              
              $
              14,298
              
              
              $
              13,396SecuritiesTaxable
              
              
              1,705
              
              
              
              2,357
              
              
              
              3,593
              
              
              
              4,979Exempt
      from federal income tax
              
              
              111
              
              
              
              71
              
              
              
              226
              
              
              
              142Federal
      funds sold and other
              
              
              13
              
              
              
              390
              
              
              
              83
              
              
              
              480Total
      interest income
              
              
              8,881
              
              
              
              9,631
              
              
              
              18,200
              
              
              
              18,997Interest
      expenseTime
      deposits
              
              
              2,452
              
              
              
              3,070
              
              
              
              5,278
              
              
              
              6,188Other
      deposits
              
              
              413
              
              
              
              930
              
              
              
              892
              
              
              
              1,921Repurchase
      agreements and federal funds purchased
              
              
              233
              
              
              
              917
              
              
              
              643
              
              
              
              1,911Federal
      Home Loan Bank advances
              
              
              90
              
              
              
              64
              
              
              
              152
              
              
              
              177Subordinated
      debentures
              
              
              137
              
              
              
              170
              
              
              
              296
              
              
              
              336Total
      interest expense
              
              
              3,325
              
              
              
              5,151
              
              
              
              7,261
              
              
              
              10,533Net
      interest income
              
              
              5,556
              
              
              
              4,480
              
              
              
              10,939
              
              
              
              8,464Provision
      for loan and lease losses
              
              
              2,720
              
              
              
              0
              
              
              
              2,983
              
              
              
              (1,425
              )Net
      interest income after provision forloan and lease
      losses
              
              
              2,836
              
              
              
              4,480
              
              
              
              7,956
              
              
              
              9,889Noninterest
      incomeService
      fees on deposits
              
              
              647
              
              
              
              706
              
              
              
              1,281
              
              
              
              1,362Trust
      income
              
              
              218
              
              
              
              216
              
              
              
              431
              
              
              
              427Other
      operating income
              
              
              251
              
              
              
              488
              
              
              
              544
              
              
              
              787Total
      noninterest income
              
              
              1,116
              
              
              
              1,410
              
              
              
              2,256
              
              
              
              2,576Noninterest
      expenseSalaries
      and employee benefits
              
              
              2,089
              
              
              
              2,148
              
              
              
              4,305
              
              
              
              4,449Occupancy
      and equipment, net
              
              
              587
              
              
              
              645
              
              
              
              1,221
              
              
              
              1,243Data
      processing
              
              
              424
              
              
              
              448
              
              
              
              863
              
              
              
              827Legal
              
              
              76
              
              
              
              83
              
              
              
              160
              
              
              
              222Audit
      and other professional
              
              
              385
              
              
              
              287
              
              
              
              737
              
              
              
              584Amortization
      of core deposit intangible asset
              
              
              116
              
              
              
              115
              
              
              
              232
              
              
              
              231Other
      operating expenses
              
              
              642
              
              
              
              610
              
              
              
              1,231
              
              
              
              1,100Total
      noninterest expense
              
              
              4,319
              
              
              
              4,336
              
              
              
              8,749
              
              
              
              8,656Income before
      income taxes
              
              
              (367
              )
              
              
              1,554
              
              
              
              1,463
              
              
              
              3,809Income
      tax expense (benefit)
              
              
              (217
              )
              
              
              507
              
              
              
              412
              
              
              
              1,233Net
      income (loss)
              
              $
              (150
              )
              
              $
              1,047
              
              
              $
              1,051
              
              
              $
              2,576Earnings
      (loss) per share
              
              $
              (0.04
              )
              
              $
              0.25
              
              
              $
              0.25
              
              
              $
              0.61Comprehensive
      income (loss)
              
              $
              (2,400
              )
              
              $
              858
              
              
              $
              (1,042
              )
              
              $
              3,173
  The
accompanying notes are an integral part of these condensed consolidated
financial statements.
 
 4
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 CONDENSED CONSOLIDATED
STATEMENTS OF CASH FLOWS
 Six
months ended June 30, 2008 and 2007
 (In
thousands of dollars) (Unaudited)
 Six
      months endedJune
      30,
                
                
                June
      30,2008
                
                
                2007Cash
      flows from operating activitiesNet
      income
                
                $
                1,051
                
                
                $
                2,576Adjustments
      to reconcile net income to net cash from operating
    activities:Depreciation
                
                
                253
                
                
                
                292Amortization
      of intangible assets
                
                
                232
                
                
                
                231Provision
      for loan and lease losses
                
                
                2,983
                
                
                
                0Reversal
      of provision for loan and lease losses
                
                
                0
                
                
                
                (1,425
                )Loss
      on sale of other real estate owned
                
                
                0
                
                
                
                8Net
      change in accrued interest receivable and other assets
                
                
                (511
                )
                
                
                1,417Net
      change in accrued interest payable and other liabilities
                
                
                (1,296
                )
                
                
                (270
                )Net
      cash from operating activities
                
                
                2,712
                
                
                
                2,829Cash
      flows from investing activitiesProceeds
      from maturities and calls of securities available for sale
                
                
                76,697
                
                
                
                121,620Purchases
      of securities available for sale
                
                
                (50,084
                )
                
                
                (39,953
                )Change
      in loans made to customers
                
                
                (40,894
                )
                
                
                (6,101
                )Purchases
      of Federal Home Loan Bank stock
                
                
                (312
                )
                
                
                0Property
      and equipment expenditures
                
                
                (634
                )
                
                
                (237
                )Proceeds
      from sales of other real estate owned
                
                
                0
                
                
                
                118Net
      cash from investing activities
                
                
                (15,227
                )
                
                
                75,447Cash
      flows from financing activitiesNet
      increase (decrease) in:Deposits
                
                
                (12,841
                )
                
                
                (25,746
                )Securities
      sold under repurchase agreements and federal funds
    purchased
                
                
                (4,602
                )
                
                
                (13,356
                )Advances
      from borrowers for taxes and insurance
                
                
                (35
                )
                
                
                147Federal
      Home Loan Bank advances
                
                
                60,000
                
                
                
                10,000Repayment
      of Federal Home Loan Bank advances
                
                
                (35,000
                )
                
                
                (15,000
                )Purchases
      of treasury stock
                
                
                (2,078
                )
                
                
                (1,241
                )Dividends
      paid
                
                
                (1,628
                )
                
                
                (1,462
                )Net
      cash from financing activities
                
                
                3,816
                
                
                
                (46,658
                )Net
      change in cash and cash equivalents
                
                
                (8,699
                )
                
                
                31,618Cash
      and cash equivalents at beginning of period
                
                
                23,634
                
                
                
                29,986Cash
      and cash equivalents at end of period
                
                $
                14,935
                
                
                $
                61,604
  The
accompanying notes are an integral part of these condensed consolidated
financial statements.
   5
 Table of Contents
   NORTHERN STATES FINANCIAL
CORPORATION
 CONDENSED CONSOLIDATED
STATEMENTS OF STOCKHOLDERS'
EQUITY
 Six
months ended June 30, 2008 and 2007
 (In
thousands of dollars, except for per share data) (Unaudited)
  AccumulatedAdditional
                  
                  
                  
                  
                  
                  
                  
                  
                  Other
                  
                  
                  TotalCommon
                  
                  
                  Paid-In
                  
                  
                  Retained
                  
                  
                  Treasury
                  
                  
                  Comprehensive
                  
                  
                  Stockholders'Stock
                  
                  
                  Capital
                  
                  
                  Earnings
                  
                  
                  Stock,
      at Cost
                  
                  
                  Income
      (Loss)
                  
                  
                  EquityBalance,
      December 31, 2006
                  
                  $
                  1,789
                  
                  
                  $
                  11,584
                  
                  
                  $
                  65,603
                  
                  
                  $
                  (5,961
                  )
                  
                  $
                  (1,552
                  )
                  
                  $
                  71,463Net
      income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  2,576
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  2,576Cash
      dividends ($.35 per share)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,462
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,462
                  )Purchase
      of 55,000 shares ofcommon
      stock as treasury stock
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,241
                  )
                  
                  
                  
                  
                  
                  
                  (1,241
                  )Unrealized
      gain on securities available for sale, net of deferred
      tax
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  597
                  
                  
                  
                  597Balance,
      June 30, 2007
                  
                  $
                  1,789
                  
                  
                  $
                  11,584
                  
                  
                  $
                  66,717
                  
                  
                  $
                  (7,202
                  )
                  
                  $
                  (955
                  )
                  
                  $
                  71,933Balance,
      December 31, 2007
                  
                  $
                  1,789
                  
                  
                  $
                  11,584
                  
                  
                  $
                  66,983
                  
                  
                  $
                  (7,202
                  )
                  
                  $
                  300
                  
                  
                  $
                  73,454Net
      income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,051
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,051Cash
      dividends ($.40 per share)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,628
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,628
                  )Purchase
      of 105,850 shares of  common stock as treasury
      stock
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (2,078
                  )
                  
                  
                  
                  
                  
                  
                  (2,078
                  )Unrealized
      loss on securities available for sale, net of deferred
      tax
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (2,093
                  )
                  
                  
                  (2,093
                  )Balance,
      June 30, 2008
                  
                  $
                  1,789
                  
                  
                  $
                  11,584
                  
                  
                  $
                  66,406
                  
                  
                  $
                  (9,280
                  )
                  
                  $
                  (1,793
                  )
                  
                  $
                  68,706
  The
accompanying notes are an integral part of these condensed consolidated
financial statements.
   6
 Table of Contents




NORTHERN
STATES FINANCIAL CORPORATION
 NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
 
 June 30,
2008
 
 (Unaudited)
 
 
 Note 1 - Basis of
Presentation
 
 The
accompanying interim condensed consolidated financial statements are prepared
without audit and reflect all adjustments which are of a normal and recurring
nature and, in the opinion of management, are necessary to present interim
financial statements of Northern States Financial Corporation (the "Company") in
accordance with accounting principles generally accepted in the United States of
America. The interim financial statements do not purport to contain all the
necessary financial disclosures covered by accounting principles generally
accepted in the United States of America that might otherwise be necessary for
complete financial statements.
 
 To
prepare financial statements in conformity with accounting principles generally
accepted in the United States of America, management makes estimates and
assumptions based on available information.  These estimates and
assumptions affect the amounts reported in the financial statements and the
disclosures provided, and future results could differ.  The allowance
for loan and lease losses and status of contingencies are particularly subject
to change.
 
 The
interim condensed financial statements should be read in conjunction with the
audited financial statements and accompanying notes (or "notes thereto") of the
Company for the years ended December 31, 2007 and 2006.  The results
of operations for the three and six month periods ended June 30, 2008, are not
necessarily indicative of the results to be expected for the full
year.
 
 Net
income was utilized to calculate earnings per share for all periods
presented.   The Company had no common stock equivalents during
the first six months of 2008 and the entire year of 2007.  The average
outstanding common shares used for earnings per share follows:
  Three
      months ended
                
                
                Six months
      endedJune
      30,
                
                
                June
      30,
                
                
                June
      30,
                
                
                June
      30,2008
                
                
                2007
                
                
                2008
                
                
                2007Average
      outstanding common shares
                
                
                4,089,348
                
                
                
                4,190,193
                
                
                
                4,132,628
                
                
                
                4,200,591
 On April
17, 2002, the Company announced that its Board of Directors had approved a stock
repurchase program that allows the Company to purchase up to 200,000 shares of
Northern States Financial Corporation stock either in open market or private
transactions.   On February 19, 2003, the Company announced that
its Board of Directors had approved an additional repurchase program to purchase
200,000 additional shares of its stock.  During the three months ended
March 31, 2008, 50,000 shares of stock were repurchased for $993,000 and during
the three months ended June 30, 2008, 55,850 shares of stock were repurchased
for $1,085,000.  At June 30, 2008, the Company had a total of 400,000
shares of treasury stock that it repurchased under these programs.  At
June 30, 2008, the stock repurchase programs have been completed with no shares
remaining to be repurchased.  Treasury stock is carried at
cost.
  
 7
 Table of Contents
 
 NORTHERN
STATES FINANCIAL CORPORATION
 NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
 
 June 30,
2008
 
 (Unaudited)
 
 Information
related to common stock was as follows:
  June
      30,
                
                
                December
      31,2008
                
                
                2007Par
      value per share
                
                $
                0.40
                
                
                $
                0.40Authorized
      shares
                
                
                6,500,000
                
                
                
                6,500,000Issued
      shares
                
                
                4,472,255
                
                
                
                4,472,255Treasury
      shares
                
                
                400,000
                
                
                
                294,150Outstanding
      shares
                
                
                4,072,255
                
                
                
                4,178,105
 
 Note 2 –
Subordinated Debentures
 
 During
September 2005, the Company issued $10 million of trust preferred securities
through Northern States Statutory Trust I, a wholly-owned grantor
trust.  The Company issued $10 million of subordinated debentures to
Northern States Statutory Trust I, which in turn issued $10 million of trust
preferred securities.  The subordinated debentures mature in September
2035.  From December 2005 until September 15, 2010, the subordinated
debentures bear interest at a rate equal to the sum of the product of 50% times
the 3-month LIBOR plus 1.80%, plus the product of 50% times 6.186%, and
thereafter at a rate equal to the 3-month LIBOR plus 1.80%.  The rate
on the subordinated debentures was 5.38113% at June 30, 2008 and is the
effective rate from June 16, 2008 through September 14, 2008.  For the
three and six months ended June 30, 2008, interest expense on the subordinated
debentures was $137,000 and $296,000.  For the three and six months
ended June 30, 2007, interest expense on the subordinated debentures was
$170,000 and $336,000.
 
 The
Company has guaranteed the payment of distributions and payments upon
liquidation or redemption of the trust preferred securities, in each case to the
extent of funds held by the Trust. The Company and the Trust believe that, taken
together, the obligations of the Company under the guarantee, the subordinated
debentures, and other related agreements provide, in the aggregate, a full,
irrevocable and unconditional guarantee, on a subordinated basis, of all of the
obligations of the Trust under the trust preferred securities. Subject to
certain limitations, the Company has the right to defer the payment of interest
on the subordinated debentures at any time, or from time to time, for a period
not to exceed 20 consecutive quarters. The trust preferred securities are
subject to mandatory redemption, in whole or in part, upon repayment of the
subordinated debentures at maturity or their earlier redemption. The
subordinated debentures are callable at par beginning in 2010, and earlier at
the discretion of the Company if certain conditions are met, and, in any event,
only after the Company has obtained Federal Reserve approval, if then required
under applicable guidelines or regulations.
   8
 Table of Contents






NORTHERN
STATES FINANCIAL CORPORATION


ITEM 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION
 AND RESULTS OF
OPERATIONS
 
 
 The following discussion focuses on the
consolidated financial condition of Northern States Financial Corporation (the
“Company”) at June 30, 2008 and the consolidated results of operations for the
three and six month periods ended June 30, 2008, compared with the same periods
of 2007.  The purpose of this discussion is to provide a better
understanding of the condensed consolidated financial statements of Northern
States Financial Corporation and the operations of its wholly owned subsidiary,
NorStates Bank (the “Bank”) and the Bank’s wholly owned subsidiary, Northern
States Community Development Corporation (“NSCDC”). This discussion should be
read in conjunction with the interim condensed consolidated unaudited financial
statements and notes thereto included herein.
 
 Statements
contained in this report that are not historical facts may constitute
forward-looking statements (within the meaning of Section 21E of the Securities
Exchange Act of 1934, as amended), which involve significant risks and
uncertainties.  The Company intends such forward-looking statements to
be covered by the safe harbor provisions for forward-looking statements
contained in the Private Securities Litigation Reform Act of 1995, and is
including this statement for purposes of invoking these safe harbor
provisions.  Forward-looking statements, which are based on certain
assumptions and describe future plans, strategies and expectations of the
Company, are generally identifiable by the use of the words "believe," "expect,"
"intend," "anticipate," "estimate," "project," "plan," or similar
expressions.  The Company's ability to predict results or the actual
effect of future plans or strategies is inherently uncertain and actual results
may differ from those predicted.  The Company undertakes no obligation
to update these forward-looking statements in the future.  The Company
cautions readers of this report that a number of important factors could cause
the Company’s actual results subsequent to June 30, 2008 to differ materially
from those expressed in forward-looking statements.  Factors that
could cause actual results to differ from those predicted and could have a
material adverse effect on the operations of the Company and its subsidiaries
include, but are not limited to, the potential for further deterioration in the
credit quality of the Company’s loan and lease portfolios, a continued increase
in nonperforming assets, uncertainty regarding the Company’s ability to
ultimately recover on loans currently on nonaccrual status, unanticipated
changes in interest rates, general economic conditions, increasing regulatory
compliance burdens or potential legislative/regulatory changes, monetary and
fiscal policies of the U.S. Government, including policies of the U.S. Treasury
and the Federal Reserve Board, the quality or composition of the Company’s loan
or investment portfolios, deposit flows, competition, demand for loan products
and financial services in the Company’s market area, and changes in accounting
principles, policies and guidelines.  These risks and uncertainties
should be considered in evaluating forward-looking statements.
 
 
 OVERVIEW
 
 Total
assets at June 30, 2008 were $639.6 million, increasing slightly by $1.4 million
from total assets of $638.2 million at December 31, 2007.  Loans
totaled $476.3 million at June 30, 2008, the highest quarter-end level in the
Company’s history, increasing $40.6 million, or 9.3 percent, from loans of
$435.7 million at December 31, 2007.  The increase in loans was
primarily due to the marketing efforts of the Company’s loan officers and the
higher borrowing needs of its customers.  Deposits at June 30, 2008
decreased $12.8 million, or 2.7 percent, compared to December 31, 2007 as the
Company lowered deposit rates to assist in increasing its net interest
income.  Securities sold under repurchase agreements at June 30, 2008
declined $17.7 million from December 31, 2007.  The Company replaced
these funds with Federal Home Loan Bank advances and borrowings of federal funds
purchased totaling $25.0 million and  $13.1 million,
respectively.
 
 
 9
 Table of Contents
 NORTHERN
STATES FINANCIAL CORPORATION
 The
Company reported a loss for the three months ended June 30, 2008
of  $150,000, or $.04 per share, compared with earnings of $1,047,000,
or $.25 per share, for the same period of 2007.  The Company recorded
a $2.7 million provision for loan losses during the quarter as nonperforming
loans totaled $19.6 million at June 30, 2008, an increase of $7.6 million from
$12.0 million at December 31, 2007.  No provision was taken during the
second quarter of 2007.
 
 Partially
offsetting the increased provision was a 24 percent increase to the Company’s
net interest income that increased $1.1 million during the second quarter of
2008 as compared to the like quarter of 2007.  The growth in net
interest income was attributable to the Company’s loan growth while the Company
decreased interest expense by lowering rates paid on deposits and
borrowings.  The net interest spread increased to 3.31 percent during
the second quarter of 2008 as compared with 2.29 percent during the same quarter
of 2007.
 
 
 CRITICAL ACCOUNTING
POLICIES
 
 Certain
critical accounting policies involve estimates and assumptions by
management.  To prepare financial statements in conformity with
accounting principles generally accepted in the United States of America,
management makes estimates and assumptions based on available
information.  These estimates and assumptions affect the amounts
reported in the financial statements and the disclosures provided, and future
results could differ. The allowance for loan and lease losses is a critical
accounting policy for the Company because management must make estimates of
losses and these estimates are subject to change.
 
 The
allowance for loan and lease losses is a valuation allowance for probable
incurred credit losses, increased by the provision for loan and lease losses and
decreased by charge-offs less recoveries.  Management estimates the
allowance balance required using past loan and lease loss experience, the nature
and volume of the portfolio, information about specific borrower situations,
estimated collateral values, economic conditions and other
factors.  Allocations of the allowance may be made for specific loans
and leases, but the entire allowance is available for any loan or lease that,
based on management’s judgment, should be charged-off.
 
 Management analyzes the adequacy of the
allowance for loan and lease losses at least quarterly.  Loans and
leases judged to be impaired, with probable incurred loss exposure, that are no
longer accruing interest, and historical net loss percentages are reviewed in
the analysis of the allowance for loan and lease losses.  Factors
consid­ered in assessing the adequacy of the allowance include: changes in
the type and volume of the loan and lease portfolio; review of the larger
credits within the Bank; historical loss experi­ence; current economic
trends and conditions; review of the present value of expected cash flows or
fair value of collateral on impaired loans and leases; portfolio growth; and
other factors management deems appropriate.  Based on management’s
analysis, the allowance for loan and lease losses at June 30, 2008 is adequate
to cover probable incurred credit losses.
 
 One of
the components of the allowance for loan losses is historical loss
experience.  Different loan classifications within the portfolio have
different loss experience ratios.  For example, loans secured by real
estate generally have a better loss experience than loans secured by other
assets.  Changes in the classification between periods can impact the
allocation for historical losses.  At June 30, 2008, approximately 85
percent of the Bank’s loans were secured by real estate, unchanged from December
31, 2007.
 
 
 10
 Table of Contents
  NORTHERN
STATES FINANCIAL CORPORATION
 Management specifically
analyzes its nonperforming loans for probable losses.  The change in
the volume of nonperforming loans may significantly impact the amount of
estimated losses specifically allocated to these loans depending on the adequacy
of the loan collateral and the borrowers’ ability to repay the
loans.  As specific allocations are done on a loan-by-loan basis, the
amount of the specific allocation is more likely subject to fluctuation than an
allocation for a pool of loans based on historical loss trends. The amount of
the allocations on nonperforming loans may fluctuate in future periods due to
changes in conditions of underlying collateral and changes in the borrowers’
ability to repay.
 
 Goodwill results from business
acquisitions and represents the excess of the purchase price over the fair value
of acquired tangible assets and liabilities and identifiable intangible
assets.  Goodwill is assessed for impairment annually and more often
if warranted by circumstances.  Any such impairment will be recognized
in the period identified.
 
 Other intangible assets consist of core
deposit and acquired customer relationship intangible assets arising from whole
bank and branch acquisitions, which is periodically evaluated for
impairment.  They are initially measured at fair value and then are
amortized on the straight-line method over their estimated useful life of seven
years.
 
 
 FINANCIAL
CONDITION
 
 The
Company’s cash and cash equivalents at June 30, 2008 were $14.9 million and have
declined $8.7 million from December 31, 2008.  The Company had no
federal funds sold at June 30, 2008 as compared with $9.2 million at December
31, 2007.  The Company’s federal funds sold position declined as this
source of liquidity was used to assist in the funding of the loan growth that
occurred during the first half of 2008.  Federal funds sold are excess
funds above what is necessary to maintain at the Federal Reserve that the
Company lends/sells to other financial institutions on an overnight
basis.  Rather than lend/sell these excess funds, the Company may use
the funds for its liquidity needs.
 
 The
Company’s securities available for sale declined $30.1 million to $123.2 million
at June 30, 2008 from $153.3 million at year-end 2007.  The liquidity
provided by the maturities and calls to the Company’s securities available for
sale during the first half of 2008 was used to fund loan growth.  The
Company has investments in collateralized debt obligations backed by financial
institutions and insurance companies at June 30, 2008 having a fair value of
$7.1 million that have unrealized losses of $3.7 million.  Management
has analyzed the payment streams on these collateralized debt obligations and
management has the intent and ability to hold these securities for the
foreseeable future.  Management expects the fair value to recover as
these securities approach their maturity dates.
 
 Loans and
leases, the largest earning asset of the Company, totaled $476.3 million at June
30, 2008, increasing $40.6 million from $435.7 million at December 31,
2007.  The increase mainly came from increases in loans to the hotel
industry secured by commercial real estate.   The Company’s loans
to the hotel industry increased $30.3 million during the first half of 2008 to
$49.8 million at June 30, 2008 from $19.5 million at December 31,
2007.
 
 The
Company’s loans are made primarily to small and midsize businesses and are
primarily secured by real estate.  Approximately 85 percent of the
Bank’s loan portfolio at June 30, 2008 was secured by real
estate.  There have been some declines in general real estate values
in our market area that may affect the collateral values of the Company’s loans
secured by real estate.  It should be noted that the Bank’s
underwriting standards require that borrowers have adequate cash flows in order
to support loan repayment.  As such, the Company carries no subprime
mortgages in its loan portfolio.  At June 30, 2008, approximately
$31.3 million of the Bank’s loans secured by 1 – 4 family and 5 plus family
residences were pledged under a blanket agreement to the Federal Home Loan Bank
to secure our borrowings and line of credit there.
 
 
 11
 Table of Contents
  NORTHERN
STATES FINANCIAL CORPORATION
 Loan commitments have
increased $18.9 million to $155.6 million at June 30, 2008 compared with $136.7
million at December 31, 2007 as loan demand continued to be strong during the
first half of 2008.  Letters of credit decreased during the first half
of 2008 to $9.3 million from $10.7 million at year-end.  At June 30,
2008, loans to related parties totaled $1.0 million and loan commitments and
letters of credit issued to related parties were $1.9 million.  Loans,
loan commitments and letters of credit to related parties are made on the same
terms and conditions that are available to the public.
 
 Deposits
at June 30, 2008 decreased $12.8 million, or 2.7 percent, from year-end
2007.  The decrease in deposits came mainly from decreases in time and
money market deposits, which decreased $8.6 million and $4.7 million,
respectively, from December 31, 2007.  Much of the decline in time
deposits came from maturities of promotional 5 month CDs offered at 5.00 percent
during the third quarter of 2007 through January 2008 that matured during the
second quarter of 2008 as the renewal rates were significantly lower than 5.00
percent.  Lower rates offered on money market deposits contributed to
the decreases to this deposit product.
 
 Securities
sold under repurchase agreements decreased by $17.7 million to $49.1 million at
June 30, 2008 from $66.8 million at December 31, 2007.  The decline
during the first half of 2008 was due to one customer who closed their $20.0
million repurchase agreement relationship.  As the repurchase
agreements decreased the Company replaced the funds with Federal Home Loan Bank
advances and short-term borrowings of federal funds purchased that totaled $25.0
million and $13.1 million, respectively, at June 30, 2008.
 
 As previously disclosed, included in
other liabilities at June 30, 2008 is $304,000 related to estimated
environmental clean-up expenses of a parcel of other real estate sold in
previous years.  The Company intends to seek reimbursement of these
expenses from the State of Illinois that has a fund for this type of clean-up.  However,
there can be no assurance that the Company will be successful in obtaining any
such reimbursement.
 
 
 FAIR VALUE
MEASUREMENTS
  The following tables present
information about the Company’s securities that were measured at fair value on a
recurring basis at June 30, 2008, and the valuation techniques used by the
Company to determine the fair values.
  In
general, fair values determined by Level 1 inputs use quoted prices in active
markets for identical securities that the Company has the ability to
access.
  Fair
values determined by Level 2 inputs use other inputs that are observable, either
directly or indirectly.  These Level 2 inputs include quoted prices
for similar securities in active markets, and other inputs such as interest
rates and yield curves that are observable at commonly quoted
intervals.
  Level 3
inputs are unobservable inputs, including inputs that are available in
situations where there is little, if any, market activity for the related
securities.
  In
instances where inputs used to measure fair value fall into different levels in
the above fair value hierarchy, fair value measurements in their entirety are
categorized based on the lowest level input that is significant to the
valuation. The Company’s assessment of the significance of particular inputs to
these fair value measurements requires judgment and considers factors specific
to each security.
  On an
annual basis the Company validates the measurement of the fair values of its
securities by sending a listing of its securities to an independent securities
valuation firm.  This independent securities valuation firm determines
the fair values of the Company’s securities portfolio that is then compared to
the fair value using the methods outlined.  When this validation was
last done at September 30, 2007, the difference between the fair value reported
and the fair value determined by the independent securities valuation firm was
considered insignificant.
  
 12
 Table of Contents
  NORTHERN
STATES FINANCIAL CORPORATION
 Disclosures concerning
securities measured at fair value are as follows:
  TABLE
1
 
 NORTHERN
STATE FINANCIAL CORPORATION
 ASSETS
MEASURED AT FAIR VALUE ON A RECURRING BASIS
 As of
June 30, 2008
 ($
000s)
  Fair
      Value Measurements at Reporting Date UsingDescription
                          
                          06/30/08
                          
                          
                          Quoted
      Prices
                            in
      Active
                            Markets
      for
                            Identical
                            Assets
                            (Level
      1)
                          
                          
                          Significant
                            Other
                            Observable
                            Inputs
                            (Level
      2)
                          
                          
                          Significant
                            Unobservable
                            Inputs
                            (Level
      3)Securities
      available for sale
                          
                          $
                          123,243
                          
                          
                          $
                          -
                          
                          
                          $
                          123,243
                          
                          
                          $
                          -
  The
Company also has assets that under certain conditions are subject to measurement
at fair value on a non-recurring basis. These assets are held to maturity loans
that are considered impaired per Financial Accounting Standard Board Statement
No. 114 (“FAS 114”).  The Company has estimated the fair values of the
impaired loans using Level 3 inputs, specifically discounted cash flow
projections.  For the quarter ended June 30, 2008, the Company’s net
change to its specific allocation to these impaired loans in order to adjust
these assets to their estimated fair values was $2,792,000.
  TABLE
2
 
 NORTHERN
STATE FINANCIAL CORPORATION
 ASSETS
MEASURED AT FAIR VALUE ON A NON-RECURRING BASIS
 As of
June 30, 2008
 ($
000s)
 
 Fair
      Value Measurements at Reporting Date UsingDescription
                    
                    06/30/08
                    
                    
                    Quoted
      Prices
                      in
      Active
                      Markets
      for
                      Identical
                      Assets
                      (Level
      1)
                    
                    
                    Significant
                      Other
                      Observable
                      Inputs
                      (Level
      2)
                    
                    
                    Significant
                      Unobservable
                      Inputs
                      (Level
      3)
                    
                    
                    Total
      Change
                      for
      the quarter
                      ended
      06/30/08Impaired
      loans accountedFor
      under FAS 114
                    
                    $
                    18,935
                    
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    18,935
                    
                    
                    $
                    2,792
 
   13
 Table of Contents
 NORTHERN
STATES FINANCIAL CORPORATION
 Impaired
loans that are accounted for under FAS 114 are categorized as Level 3 for fair
value measurement.  The Company estimates the fair value of the loans
are based on the present value of expected future cash flows using management’s
best estimate of key assumptions.  These assumptions include future
payment ability, timing of payment streams, and estimated realizable values of
available collateral (typically based on outside appraisals).
 
 Other
assets, including goodwill, intangible assets and other assets acquired in
business combinations, are also subject to periodic impairment assessments under
other accounting principles generally accepted in the United States of America.
These assets are not considered financial instruments.  Effective
February 12, 2008, the FASB issued a staff position, FSP FAS 157-2, which
delayed the applicability of FAS 157 to non-financial
instruments.  Accordingly, these assets are not included for purposes
of the above disclosures.
 
 
 CAPITAL
 
 Total
stockholders’ equity decreased $4.7 million to $68.7 million during the six
months ended June 30, 2008.  Items causing a reduction to
stockholders’ equity were an adjustment of $2,093,000 for the unrealized loss on
securities available for sale, net of deferred tax, purchases of 105,850 shares
of treasury stock for $2,078,000 and a payment of a $.40 per share cash dividend
to stockholders on June 1, 2008 that totaled $1,628,000.  These
decreases to stockholders’ equity during the first half of 2008 were offset by
$1,051,000, the net income for the six months ended June 30,
2008.  The book value of the Company’s common stock at June 30, 2008
was $16.87 per share.
 
 On a
consolidated basis, the Company’s Tier 1 to total assets ratio and total capital
to assets ratio, on a risk adjusted basis, were 11.10 percent and 13.96 percent,
respectively, at June 30, 2008 and exceed the regulatory minimum for
capital adequacy purposes.  Management believes that the capital
position of both the Company and the Bank are appropriate for current projected
needs.
 
 
 LIQUIDITY
 
 The
Company’s liquidity is measured by the ability to raise funds through deposits,
borrowed funds, capital or cash flow from the repayment or maturities of loans
and securities and net profits.   Liquidity is primarily managed through
the growth of deposits and by liquid assets such as cash and due from banks less
any reserve requirements, securities available for sale less any pledged
securities and federal funds sold.  Asset and liability management is the
process of managing the balance sheet to achieve a mix of earning assets and
liabilities in such a way that achieves an interest rate risk profile acceptable
to management and assists in achieving a desired level of profitability.
 An important part of the overall asset and liability management process is
providing adequate liquidity.  Liquid assets at the Bank consist of
cash and equivalents less any Federal Reserve Bank deposit requirements plus
unpledged securities available for sale.  The Bank’s liquid assets
totaled $47.1 million at June 30, 2008 as compared with $46.5 million at
December 31, 2007.
 
 Management
reviews the liquidity ratio and as well as its sources and uses of funds
weekly.  The liquidity ratio is the net liquid assets divided by net
deposits and short-term liabilities.  At June 30, 2008, this ratio at
the Bank was 9.98 percent, slightly below management’s internal policy
guidelines by 2 basis points.
 
 Liquidity
management involves the Company’s ability to meet the cash flow requirements of
customers.  The Company needs to have sufficient cash flow to meet
borrowers needs to fund loans or the requirements of depositors wanting to
withdraw funds.  The statements of cash flows shows that for the six
months ended June 30, 2008 cash and cash equivalents decreased by $8.7 million
to $14.9 million.
 
 14
 Table of Contents
 NORTHERN
STATES FINANCIAL CORPORATION
 Federal
funds sold, interest bearing deposits in banks and available for sale
securities, particularly those of shorter maturities, are principal sources of
liquidity.  There were no federal funds sold at June 30, 2008 as
compared with $9.2 million at December 31, 2007.  The Company
classifies all of its securities as available for sale, which increases the
Company's flexibility in that the Company can use its unpledged securities to
meet liquidity requirements by increasing its repurchase agreement
balances.  Securities available for sale totaled $123.2 million at
June 30, 2008 of which $86.2 million were pledged to secure public deposits and
repurchase agreements as compared with pledged securities of  $125.3
million at December 31, 2007.
 
 The
Company can sell unpledged securities for liquidity purposes prior to their
maturity date.  Subsequent to June 30, 2008, the Company sold
securities with a carrying value of $3.0 million for liquidity purposes and
recognized gain of $17,000 from the sale.
 
 During
the six months of 2008, the Company had incoming cash flows from maturities and
calls of securities available for sale of $76.7 million while it had cash
outflows for purchases of securities of $50.1 million.  These
securities activities during the first half of 2008 provided liquidity of $26.6
million, which was used to help meet the cash flows for funding loans and
deposit reductions.
 
 An
important source of liquidity to the Company is deposits.  The Company
may use brokered deposits as a source of liquidity.  During the six
months ended June 30, 2008 increased its brokered deposits by $6.0 million to
$49.8 million, amounting to 10.6 percent of total deposits, to meet the
Company’s liquidity needs.  Subsequent to June 30, 2008, the Company
took in an additional $14.0 million in brokered deposits for liquidity
purposes.
 
 Another important source of liquidity
to the Company is borrowings in the form of repurchase agreements and Federal
Home Loan Bank advances.  During the first half of 2008, borrowings
through repurchase agreements decreased $17.7 million as one repurchase
agreement relationship of $20.0 million was closed. The Company is carrying
$25.0 million at June 30, 2008 in Federal Home Loan Bank (“FHLB”) advances.
During the first half of 2008, the Company drew on its line of credit with the
FHLB in the amount of $60.0 million, while paying down the advances by $35.0
million.  In order to increase its line of credit available from the
FHLB, the Company increased its investment in FHLB stock by $312,000 during the
first six months of 2008.  The Company has made a blanket pledge of
its 1-4 family and 5 plus family real estate mortgage loans totaling $31.3
million to the FHLB for this credit line as well.  At June 30, 2008,
the Company has an additional $6.3 million available to draw at the
FHLB.
 
 The
Company also uses short-term borrowings for federal funds purchased to assist
its liquidity needs.  At June 30, 2008, the Company had overnight
borrowings of federal funds purchased totaling $13.1 million from two
independent banks with an additional $21.9 million funds available from these
independent banks.  During the second quarter of 2008, the Company
opened a relationship from a third independent bank and received an additional
$10.0 million line of credit for overnight borrowings.  There was a
total of $31.9 million available at June 30, 2008 from these combined lines of
credit to help ensure the Company’s ability to meet any funding needs, including
any unexpected strain on liquidity.
 
 
 RESULTS OF
OPERATIONS
 
 NET
INCOME
 
 The
Company posted a net loss of $150,000 for the quarter ended June 30, 2008 as
compared with net income of $1,047,000, for the same quarter of
2007.  Despite growth of  $1.1 million to net interest
income, a 24 percent increase, for the second quarter ended June 30, 2008, an
increase in its provision for loan and lease losses totaling $2.7 million
resulted in the Company recording a net loss for the period.
 
 
 15
 Table of Contents
 
 NORTHERN
STATES FINANCIAL CORPORATION
 For the
six months ended June 30, 2008, net income was $1,051,000 as compared with
$2,576,000 for the first half of 2007. The annualized return on average assets
for the first half of 2008 was .33 percent, decreasing from .75 percent for the
same period of 2007.   The decrease in net income for the six
months ended June 30, 2008 was due to the provision for loan and lease losses of
$3.0 million during the first half of 2008 necessitated by increased levels of
nonperforming loans as compared with a $1.4 million reduction to the provision
for loan and lease losses during the first half of 2007, when the nonperforming
loan portfolio improved.
 
 
 NET
INTEREST INCOME
 
 Net
interest income, the difference between interest income on earning assets and
interest expense on interest bearing liabilities, increased 24 percent to $5.6
million for the second quarter of 2008, an increase of $1.1 million as compared
with $4.5 million for the same quarter of 2007.  The growth to net
interest income was attributable to increased interest income from loan growth
while the Company significantly decreased interest expense by lowering rates
paid on deposits and borrowings.
 
 Interest
income from earning assets during the second quarter of 2008 declined $750,000
from the same quarter last year.  The lower volume of interest earning
assets coupled with generally lower interest rates the second quarter of 2008 as
compared to the same quarter of 2007 account for this
decrease.   Table 3 shows that average interest earning assets
were $601.5 million during the second quarter of 2008, $30.4 million less as
compared with $631.9 million during the same quarter of
2007.  However, average loans, the interest earning asset that
generally yield the highest rate of interest for the Company, were $89.3 million
greater in the second quarter of 2008 than for the same quarter of
2007.  Corresponding loan interest income on a fully tax equivalent
basis was $244,000 greater during the second quarter of 2008 than for the same
quarter last year.  General interest rates were lower as evidenced by
the prime lending rate, which was 5.00 percent at June 30, 2008, as compared
with 8.25 percent at June 30, 2007.  The effect of the lower interest
rates is evidenced in Table 3 that shows that yields earned on average interest
earning assets declined 16 basis points to 5.96 percent during the second
quarter of 2008 as compared with 6.12 percent for the like quarter of
2007.
 
 Interest
expense declined $1.8 million in the second quarter of 2008 as compared with the
same quarter of 2007.  Interest expense declined as the volume of
average interest bearing liabilities decreased during the second quarter of 2008
by $36.9 million to $501.2 million compared with $538.1 million during the same
period of 2007.  During 2007 and into 2008, in order to lower its
interest expense, the Company began offering lower rates on its deposit products
even though it meant that deposit balances would decline.  The effect
of this strategy is evidenced during the second quarter of 2008 where rates paid
on interest bearing liabilities declined 118 basis points to 2.65 percent as
compared with the same quarter of 2007.
 
 The net
interest rate spread increased 102 basis points to 3.31 percent for the second
quarter of 2008 compared to 2.29 percent for the same quarter of
2007.  The increased net interest spread shows that yields on interest
earning assets declined at a much slower speed than the decreases to rates paid
on interest bearing liabilities.  An important factor to consider is
that the Company’s loan growth mitigated some of the effect of the lower general
interest rates in 2008 as loans yields are generally higher than yields on
securities and federal funds sold.
 
 Table 4
shows that during the six months ended June 30, 2008, net interest income on a
fully tax equivalent basis increased $2.5 million compared with the same period
of 2007.  Average yields on interest earning assets increased 15 basis
points to 6.09 percent during the six months ended June 30, 2007 as compared
with the same six months last year while average rates paid on interest bearing
liabilities decreased by 97 basis points, causing the growth to the net interest
spread.
  
 16
 Table of Contents
  NORTHERN
STATES FINANCIAL CORPORATION
 TABLE 3
 NORTHERN
STATES FINANCIAL CORPORATION
 ANALYSIS
OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
 For the
Three Months Ended June 30, 2008 and 2007 - Rates are Annualized
 ($
000s)
  2008
                  
                  
                  2007Average
                    Balance
                  
                  
                  Interest
                  
                  
                  Rate
                  
                  
                  AverageBalance
                  
                  
                  Interest
                  
                  
                  RateAssetsLoans
      (1)(2)(3)
                  
                  $
                  463,369
                  
                  
                  $
                  7,075
                  
                  
                  
                  6.11
                  %
                  
                  $
                  374,025
                  
                  
                  $
                  6,831
                  
                  
                  
                  7.31
                  %Taxable
      securities (4)
                  
                  
                  125,124
                  
                  
                  
                  1,705
                  
                  
                  
                  5.45
                  %
                  
                  
                  222,326
                  
                  
                  
                  2,357
                  
                  
                  
                  4.22
                  %Tax
      advantaged securities (2) (4)
                  
                  
                  10,731
                  
                  
                  
                  169
                  
                  
                  
                  6.33
                  %
                  
                  
                  7,654
                  
                  
                  
                  107
                  
                  
                  
                  5.59
                  %Federal
      funds sold
                  
                  
                  2,303
                  
                  
                  
                  13
                  
                  
                  
                  2.26
                  %
                  
                  
                  27,915
                  
                  
                  
                  390
                  
                  
                  
                  5.59
                  %Interest
      earning assets (4)
                  
                  
                  601,527
                  
                  
                  
                  8,962
                  
                  
                  
                  5.96
                  %
                  
                  
                  631,920
                  
                  
                  
                  9,685
                  
                  
                  
                  6.12
                  %Noninterest
      earning assets
                  
                  
                  37,470
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  44,102Average
      assets
                  
                  $
                  638,997
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  676,022Liabilities andStockholders'
      EquityNOW
      deposits
                  
                  $
                  48,006
                  
                  
                  $
                  40
                  
                  
                  
                  0.33
                  %
                  
                  $
                  49,653
                  
                  
                  $
                  101
                  
                  
                  
                  0.81
                  %Money
      market deposits
                  
                  
                  68,742
                  
                  
                  
                  295
                  
                  
                  
                  1.72
                  %
                  
                  
                  75,691
                  
                  
                  
                  703
                  
                  
                  
                  3.72
                  %Savings
      deposits
                  
                  
                  63,595
                  
                  
                  
                  78
                  
                  
                  
                  0.49
                  %
                  
                  
                  66,612
                  
                  
                  
                  125
                  
                  
                  
                  0.75
                  %Time
      deposits
                  
                  
                  245,477
                  
                  
                  
                  2,452
                  
                  
                  
                  4.00
                  %
                  
                  
                  252,892
                  
                  
                  
                  3,070
                  
                  
                  
                  4.86
                  %Other
      borrowings
                  
                  
                  75,400
                  
                  
                  
                  460
                  
                  
                  
                  2.44
                  %
                  
                  
                  93,246
                  
                  
                  
                  1,152
                  
                  
                  
                  4.94
                  %Interest
      bearing liabilities
                  
                  
                  501,220
                  
                  
                  
                  3,325
                  
                  
                  
                  2.65
                  %
                  
                  
                  538,094
                  
                  
                  
                  5,151
                  
                  
                  
                  3.83
                  %Demand
      deposits
                  
                  
                  58,383
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  57,578Other
      noninterest bearing liabilities
                  
                  
                  7,451
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  8,258Stockholders'
      Equity
                  
                  
                  71,943
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  72,092Average
      Liabilities
      andStockholders'Equity
                  
                  $
                  638,997
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  676,022Net
      interest income
                  
                  
                  
                  
                  
                  $
                  5,637
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  4,534Net
      interest spread
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  3.31
                  %
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  2.29
                  %Net
      yield on interest earning assets (4)
                  
                  
                  
                  3.75
                  %
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  2.86
                  %Interest-bearing
      liabilities to earning assets ratio
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  83.32
                  %
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  85.15
                  %
  (1)
                Interest
      income on loans includes loan origination and other fees of $63,000 and
      $196,000 for the three months ended June 30, 2008 and
  2007.
  (2)
                Tax-exempt
      income is reflected on a fully tax equivalent basis utilizing a 34 percent
      tax rate.  The tax equivalent adjustment reflected in the
      above table for municipal loans is approximately $23,000 and $18,000 for
      the three months ended June 30, 2008 and 2007.  The tax
      equivalent adjustment reflected in the above table for tax advantaged
      securities is approximately $58,000 and $36,000 for the three months ended
      June 30, 2008 and 2007.
  (3)
                Non-accrual
      loans are included in average
loans.
  (4)
                  Rate
      information was calculated on the average amortized cost for
      securities.  The three months ended June 30, 2008 and 2007
      average balance information includes an average unrealized gain (loss) for
      taxable securities of ($72,000) and ($1,241,000) and for tax-advantaged
      securities of $49,000 and $0.
   17
 Table of Contents
  NORTHERN
STATES FINANCIAL CORPORATION
  TABLE
4
 
 NORTHERN
STATES FINANCIAL CORPORATION
 ANALYSIS
OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
 For the
Six Months Ended June 30, 2008 and 2007 - Rates are Annualized
 ($
000s)
 2008
                
                
                2007Average
                  Balance
                
                
                Interest
                
                
                Rate
                
                
                Average
                  Balance
                
                
                Interest
                
                
                RateAssetsLoans
      (1)(2)(3)
                
                $
                454,808
                
                
                $
                14,343
                
                
                
                6.31
                %
                
                $
                373,849
                
                
                $
                13,431
                
                
                
                7.19
                %Taxable
      securities (4)
                
                
                132,195
                
                
                
                3,593
                
                
                
                5.46
                %
                
                
                242,356
                
                
                
                4,979
                
                
                
                4.08
                %Tax
      advantaged securities (2) (4)
                
                
                10,985
                
                
                
                343
                
                
                
                6.26
                %
                
                
                7,711
                
                
                
                215
                
                
                
                5.58
                %Federal
      funds sold
                
                
                5,765
                
                
                
                83
                
                
                
                2.88
                %
                
                
                17,242
                
                
                
                480
                
                
                
                5.57
                %Interest
      earning assets (4)
                
                
                603,753
                
                
                
                18,362
                
                
                
                6.09
                %
                
                
                641,158
                
                
                
                19,105
                
                
                
                5.94
                %Noninterest
      earning assets
                
                
                37,059
                
                
                
                
                
                
                
                
                
                
                
                41,777Average
      assets
                
                $
                640,812
                
                
                
                
                
                
                
                
                
                
                $
                682,935Liabilities
      and Stockholders'
      EquityNOW
      deposits
                
                $
                45,785
                
                
                $
                79
                
                
                
                0.35
                %
                
                $
                49,609
                
                
                $
                198
                
                
                
                0.80
                %Money
      market deposits
                
                
                69,457
                
                
                
                645
                
                
                
                1.86
                %
                
                
                76,623
                
                
                
                1,472
                
                
                
                3.84
                %Savings
      deposits
                
                
                62,563
                
                
                
                168
                
                
                
                0.54
                %
                
                
                67,127
                
                
                
                251
                
                
                
                0.75
                %Time
      deposits
                
                
                248,511
                
                
                
                5,278
                
                
                
                4.25
                %
                
                
                256,727
                
                
                
                6,188
                
                
                
                4.82
                %Other
      borrowings
                
                
                77,315
                
                
                
                1,091
                
                
                
                2.82
                %
                
                
                96,888
                
                
                
                2,424
                
                
                
                5.00
                %Interest
      bearing liabilities
                
                
                503,631
                
                
                
                7,261
                
                
                
                2.88
                %
                
                
                546,974
                
                
                
                10,533
                
                
                
                3.85
                %Demand
      deposits
                
                
                56,945
                
                
                
                
                
                
                
                
                
                
                
                56,471Other
      noninterest bearing liabilities
                
                
                7,207
                
                
                
                
                
                
                
                
                
                
                
                7,847Stockholders'
      Equity
                
                
                73,029
                
                
                
                
                
                
                
                
                
                
                
                71,643Average
      Liabilities
      and Stockholders' Equity
                
                $
                640,812
                
                
                
                
                
                
                
                
                
                
                $
                682,935Net
      interest income
                
                
                
                
                
                $
                11,101
                
                
                
                
                
                
                
                
                
                
                $
                8,572Net
      interest spread
                
                
                
                
                
                
                
                
                
                
                3.21
                %
                
                
                
                
                
                
                
                
                
                
                2.09
                %Net
      yield on interest earning       
      assets (4)
                
                
                
                
                
                
                
                
                
                
                3.68
                %
                
                
                
                
                
                
                
                
                
                
                2.67
                %Interest-bearing
      liabilities to earning assets ratio
                
                
                
                
                
                
                
                
                
                
                83.42
                %
                
                
                
                
                
                
                
                
                
                
                85.31
                %
  (1)
                Interest
      income on loans includes loan origination and other fees of $95,000 and
      $256,000 for the six months ended June 30, 2008 and
  2007.
  (2)
                Tax-exempt
      income is reflected on a fully tax equivalent basis utilizing a 34 percent
      tax rate.  The tax equivalent adjustment reflected in the above
      table for municipal loans is approximately $45,000 and $35,000 for the six
      months ended June 30, 2008 and 2007.  The tax equivalent
      adjustment reflected in the above table for tax advantaged securities is
      approximately $117,000 and $73,000 for the six months ended June 30, 2008
      and 2007.
  (3)
                Non-accrual
      loans are included in average
loans.
  (4)
                  Rate
      information was calculated on the average amortized cost for
      securities.  The six months ended June 30, 2008 and 2007 average
      balance information includes an average unrealized gain (loss) for taxable
      securities of $538,000 and ($1,756,000) and for tax-advantaged securities
      of $29,000 and $1,000.
   18
 Table of Contents
 NORTHERN
STATES FINANCIAL CORPORATION
 If
interest rates remain stable for the balance of 2008, management believes that
net interest income will continue to improve.  A majority of its loans
are at fixed rates and the Company believes that it will maintain the yields
earned on these loans as prepayment penalties will deter borrowers from
refinancing many of these loans.  A sizable amount of the Company’s
variable rate loans have interest rate floors that do not allow the loan yield
to decrease any further.  On the deposit side of the balance sheet,
the Company has significantly lowered rates offered on time
deposits.  Management believes that its cost of funds will decline as
time deposits mature and reprice at lower rates in the second half of
2008.  The Company constantly reviews its net interest income and
implements strategies to increase its net yield on interest earning
assets.
 
 
 ASSET
QUALITY AND THE PROVISION FOR LOAN AND LEASE LOSSES
 
 At June 30, 2008, management, with the
concurrence of the Board of Directors, after carefully reviewing the adequacy of
the allowance for loan and lease losses and the levels of nonperforming and
impaired loans and leases, determined that an allowance of $7.6 million was
adequate to cover probable incurred loan and lease losses as compared with $4.6
million at year-end 2007.  During the first half of 2008, $82,000 in
loans and leases were charged off against the allowance compared with charge
offs of $2.1 million during the same period last year.  Recoveries of
loans previously charged off during the six months ended June 30, 2008 totaled
$54,000 as compared with $49,000 in recoveries during the same period in
2007.  During the second quarter of 2008, the provision for loan and
lease losses was $2.7 million and the provision for the six months ended June
30, 2008 totaled $3.0 million.  There was no provision for loan and
lease losses during the second quarter of 2007 and for the six months ended June
30, 2007 the provision total was a reduced by $1.4 million.
 
 Nonperforming
loans and leases, which includes loans and leases on nonaccrual status in
addition to loans and leases 90 days or more past due and still accruing
interest, were $19.6 million at June 30, 2008, or 4.11 percent of total loans
and leases, as compared with $12.0 million at December 31, 2007, or 2.75 percent
of loans and leases.   During the first quarter of 2008 the
Company received payoffs and principal reductions on $6.4 million of
nonperforming loans that the Company had been carrying on nonaccrual status at
December 31, 2007.  Additions to the nonperforming loans during the
second quarter of 2008 that were placed on nonaccrual status include a $9.0
million loan on a renovated luxury home, a construction loan for $1.7 million,
and loans totaling $1.1 million to a borrower secured by commercial
properties.  A $2.2 million home equity classified as nonperforming
during the first quarter of 2008 remained on nonaccrual status at June 30,
2008.
 
 The $9.0
million loan placed on nonaccural status during the quarter ended June 30, 2008
is secured by a luxury home on 7.5 acres.  The borrower extensively
renovated the home and the loan was placed on nonaccrual status, as the borrower
has been unable to sell the property.  The Company allocated $2.2
million of its allowance for loan and lease losses specifically to this loan at
June 30, 2008.
 
 A loan
for the construction of 145 condominiums in Texas, in which the Bank is a
participant with the Bank’s portion of the loan at $1.7 million at June 30,
2008, was placed on nonaccrual status during the second quarter of
2008.  Structural problems have delayed the completion of the
building.  At June 30, 2008, the Company has allocated $500,000 of its
allowance for loan and lease losses specifically to this loan.  As
more information is made available from the project’s engineers as to the
structural problems and the cost to correct them, the allowance allocated to
this loan may be adjusted.
 
 Additional
loans totaling $1.1 million secured by business properties were also placed on
nonaccrual status during the quarter ended June 30, 2008 as the borrower
experienced cash flow difficulties.  The analysis of the market value
of the properties is in excess of $1.1 million and as such the Company has not
made a specific allocation of the allowance for loan and lease losses for this
loan at June 30, 2008.
 
 
 19
 Table of Contents
  NORTHERN
STATES FINANCIAL CORPORATION
 Impaired
loans and leases at June 30, 2008 totaled $18.9 million as compared with $10.7
million at December 31, 2007.  The Company considers a loan or lease
impaired if full principal and interest will not be collected under the
contractual terms of the note.  Nonaccrual loans and leases are
classified as impaired.  Impaired loans and leases are carried at the
present value of expected cash flows discounted at the loan's effective interest
rate or at the fair value of the collateral less selling costs, if the loan or
lease is collateral dependent.  At June 30, 2008, $3.3 million of the
allowance for loan and lease losses was allocated to the impaired
loans.
 
 Another
component of nonperforming assets is other real estate owned, consisting of
assets acquired through loan foreclosure and repossession. At June 30, 2008,
other real estate owned totaled $2.9 million, unchanged from December 31, 2007
and consists of two separate properties.  The fair value of other real
estate owned is reviewed by management at least quarterly to help ensure the
reasonableness of its carrying value, which is the lower of cost or the fair
value less estimated selling costs.
 
 Other
real estate owned includes a property acquired in 1987 through the receipt of
deed in lieu of foreclosure.  This property is a former
commercial/industrial site located overlooking Lake Michigan in Waukegan,
Illinois, with a carrying value of $1,710,000 at June 30, 2008.  The
Company is attempting to sell this property through the Bank’s subsidiary,
Northern States Community Development Corporation as part of the City of
Waukegan’s lakefront development plans.  A problem with the
development of this real estate is the need to move railroad tracks that are
adjacent to the property.  The City of Waukegan has been in
negotiations with the railroad to move these tracks as part of the city’s
Lakefront Downtown Master Plan.
 
 This
property is a former commercial/industrial site and environmental remediation
costs may be incurred in disposing of this property.  During the
quarter ending December 31, 2007, the Company hired an independent environmental
consultant to provide an opinion as to estimated environmental remediation costs
with this property.  The report estimated that the costs involved
would be approximately $1,600,000 to achieve acceptable levels of contaminants
for commercial/industrial or residential land use and to prevent migration of
contaminants to adjoining off-site properties and Lake Michigan.  No
determination has yet been made as to the ultimate end use of the property,
which would need to be approved by the City of Waukegan as part of its Lakefront
Downtown Master Plan. The appraised value of the property supports the Company’s
carrying value plus the estimated remediation costs and as such, at this time no
liability has been recorded for these estimated environmental remediation
costs.
 
 At June 30, 2008, the Company is also
carrying $1.2 million as other real estate owned on a property consisting of a
two-story office building in Waukegan, Illinois that had been transferred to
other real estate owned in 2004.  The Company is actively attempting
to sell the property.
 
 
 NONINTEREST
INCOME
 
 Noninterest
income for the three months ended June 30, 2008 was $1,116,000, decreasing
$294,000 as compared with $1,410,000 for the three months ended June 30,
2007.  The majority of the decrease to noninterest income was a result
of the recognition of a one-time gain of $148,000 during the three months ended
June 30, 2007 from the sale of the Bank’s land trust area.  Service
fees on deposits also declined $59,000 during the second quarter of 2008 as
compared with the same quarter last year as overdraft fee income
decreased.  Also contributing to the decrease to noninterest income
was a $38,000 reduction in mortgage banking service fee income during the second
quarter of 2008 as compared with the same quarter of 2007 as home mortgage
activities declined due to the general slow-down in home sales.
 
 Many of these same factors, including
the one-time gain on the sale of the land trust area of $148,000 during the
first half of 2007, caused noninterest income to decline for the first half of
2008 by $320,000 as compared to the same period of 2007.  Service fees
on deposits were $81,000 less during the six months ended June 30, 2008 due to
decreases to overdraft fee income and mortgage banking service fee income was
$78,000 less.
   20
 Table of Contents
  NORTHERN
STATES FINANCIAL CORPORATION
 NONINTEREST
EXPENSE
 
 Noninterest
expense for the quarter ended June 30, 2008 was $4.3 million, decreasing
slightly by $17,000 from the same quarter of 2007.  The Company’s
efficiency ratio, noninterest expense divided by the sum of net interest income
and noninterest income, was 64.7 percent for the second quarter of 2008 as
compared with 73.6 percent for the same quarter of 2007 and was positively
affected by the increased net interest income.
 
 In
comparing noninterest expenses for the second quarter of 2008 to the same
quarter of 2007, decreases to salaries and employee benefits of $59,000 and
occupancy and equipment expenses of $58,000 were largely offset by increases of
$98,000 to audit and other professional expenses.  Audit and other
professional expenses increased due to professional fees relating to marketing
research and assistance in the development of a marketing plan.  As
the marketing plan is still in development, these professional expenses are
expected to continue to be above 2007’s levels during the balance of
2008.
 
 Noninterest
expense for first half of 2008 totaled $8.7 million, increasing $93,000 from the
same period of 2007. The Company’s efficiency ratio for the six months ended
June 30, 2008 was 66.3 percent as compared with 78.4 percent for the same period
of 2007.  A lower efficiency ratio indicates improved performance and
reflects the increased net interest income during the first half of 2008 and the
containment of noninterest expenses during that time period.
 
 Components of noninterest expense
showing improvement for the six months ended June 30, 2008 as compared with the
same six months of 2007 were salaries and employee benefits, which decreased by
$144,000, and legal expense, which decreased by $62,000.  Salaries and
employee benefits have declined as the number of full time equivalent employees
has been reduced to 155 at June 30, 2008 as compared with 160 at June 30,
2007.  Legal expense decreased as one of the Bank’s major
nonperforming loans was settled during the first quarter of 2008.  As
nonperforming loans have risen in 2008, it is expected that this expense will
increase in future quarters.
 
 Offsetting these reductions to salaries
and legal expenses during the first half of 2008 as compared with the first half
of 2007 were increases to audit and other professional fees of $153,000 and to
other operating expenses of $131,000.  Audit and other professional
fees increased as the Company has contracted for assistance with marketing
research and for the development of marketing strategies.  Other
operating expenses increased as expenses relating to nonperforming assets
increased $99,000 and FDIC expense increased $42,000 during the first half of
2008.  It is expected that these expenses will continue to increase in
future quarters.
 
 FEDERAL
AND STATE INCOME TAXES
 
 For
the three months ended June 30, 2008, the Company had a tax benefit of $217,000
as compared with income taxes of $507,000 for the same three months last
year.  The tax benefit resulted from the pretax loss of $367,000
during the second quarter of 2008.
 
 The Company had tax expense of $412,000
for the six months ended June 30, 2008 as compared with a tax expense of
$1,233,000 for the same period of 2007.  As a percentage of pre-tax
income, tax expense was 28.2 percent for the six months ended June 30, 2008 and
32.4 percent for the same period of 2007.  The tax rates declined in
2008 due to lower pretax income as the provision for loan losses
increased.
 
 The Company earned $985,000 of interest
income from U.S. Treasury and U.S. government-sponsored entity securities that
was not subject to state income tax during the first half of 2008 as compared
with $4.4 million during the first half of 2007.  This decrease in
state tax-exempt income from U.S. Treasury and U.S. government-sponsored entity
securities was planned by the Company as in previous years the Company built up
sizable tax credits with the state.  The Company needs to generate
taxable income for state tax return purposes within 11 years that will use up
these tax credits or the Company will need to reverse these
credits.
   21
 Table of Contents
 NORTHERN
STATES FINANCIAL CORPORATION
 CONTRACTUAL OBLIGATIONS AND
OFF-BALANCE SHEET ARRANGEMENTS
 
 The
Company has contractual obligations that may not appear on the balance
sheet.  Table 5 presents the Company’s significant fixed and
determinable contractual obligations as of June 30, 2008, by payment date. The
payment amounts in Table 5 represent those amounts contractually due to the
recipient and do not include any unamortized premiums or discounts or similar
carrying amount adjustments.
 
 TABLE
5
 
 NORTHERN
STATE FINANCIAL CORPORATION
 CONTRACTUAL
OBLIGATIONS
 As of
June 30, 2008
 ($
000s)
  Contractual
      obligations
                
                One
      year or less
                
                
                Greater
      than 1 yr. and less than or equal to 3 yrs.
                
                
                Greater
      than 3 yrs. and less than or equal to 5 yrs.
                
                
                Greater
      than 5 yrs.
                
                
                TotalLong-term
      debtFederal
      Home Loan Bank advances
                
                $
                25,000
                
                
                $
                0
                
                
                $
                0
                
                
                $
                0
                
                
                $
                25,000Subordinated
      debentures
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                10,000
                
                
                
                10,000Time
      deposits
                
                
                187,046
                
                
                
                47,593
                
                
                
                0
                
                
                
                0
                
                
                
                234,639Other
      contractual obligationsStandby
      letters of credit
                
                
                9,310
                
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                9,310Community
      Reinvestment Act investment commitment
                
                
                51
                
                
                
                0
                
                
                
                0
                
                
                
                0
                
                
                
                51
 ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
 The
Company’s primary market risk exposure is interest rate risk and, to a lesser
extent, liquidity risk. Interest rate risk is the exposure of a banking
organization’s financial condition to adverse movements in interest
rates.  The Company seeks to achieve consistent growth in net interest
income and net income while managing volatility that arises from shifts in
interest rates.   The Company’s Asset and Liability Management
Committee (“ALCO”) oversees interest rate risk programs instituted by management
and measurements of interest rate risk to determine that they are within
authorized limits set by the Company’s Board of Directors.
 
 Evaluating
a financial institution’s exposure to changes in interest rates includes
assessing both the adequacy of the management process used to control interest
rate risk and the organization’s quantitative level of exposure.  When
assessing the interest rate risk management process, the Company seeks to ensure
that appropriate policies, procedures, management information systems and
internal controls are in place to maintain interest rate risk at prudent levels
with consistency and continuity.  Evaluating the quantitative level of
interest rate risk exposure requires the Company to assess the existing and
potential future effects of changes in interest rates on its consolidated
financial condition, including capital adequacy, earnings, liquidity, and, where
appropriate, asset quality.
 
 22
 Table of Contents
 NORTHERN
STATES FINANCIAL CORPORATION
  The
primary approach used by management to analyze interest rate risk is to
periodically evaluate the “shock” to net interest income of an assumed
instantaneous decrease and increase in rates of 1% and 2% using computer
simulation to show the effect of rate changes on the base 12 month projected net
interest income.  This approach falls under the broad definition of
asset/liability management.
 
 Several
ways the Company can manage interest rate risk include: selling existing assets
or repaying certain liabilities and matching repricing periods for new assets
and liabilities, for example, by shortening terms of new loans or
securities.  Financial institutions are also subject to prepayment
risk in a falling rate environment.  For example, a debtor may prepay
financial assets so that the debtor may refinance obligations at new, lower
rates.  Prepayments of assets carrying higher rates reduce the
Company’s interest income and overall asset yields.  The Company
attempts to lessen prepayment risk by having prepayment penalties on commercial
purpose loans.  A large portion of an institution’s liabilities may be
short term or due on demand, while most of its assets may be invested in
longer-term loans or securities. Accordingly, the Company seeks to have in place
sources of cash to meet short-term demands.  These funds can be
obtained by increasing deposits, borrowing, or selling assets.
 
 Financial
institutions are also subject to interest rate risk in a rising rate
environment.  Call features on securities may not be exercised and
lower yielding securities may remain in the Company’s securities portfolio until
maturity.
 
 Table
6 shows how interest rate shocks of decreasing rates 1% and 2% and increasing
rates 1% and 2% affect projected 12 month projected net interest income at June
30, 2008 and December 31, 2007.  The computer simulation model used to
do the interest rate shocks and calculate the effect on projected net interest
income takes into consideration maturity and repricing schedules of the various
assets and liabilities as well as call provisions on the Company’s
securities.
 
 At June
30, 2008 the projected net interest income increases $34,000 when rates are
shocked upward 2% while projected net interest income decreases $580,000 for a
2% downward rate shock.   At December 31, 2007 projected net
interest income increased $418,000 when rates were shocked upward 2% while
projected net interest income decreased by $222,000, for a 2% downward rate
shock.  This indicates that the balance sheet was asset sensitive at
both June 30, 2008 and December 31, 2007.
 
 At both
June 30, 2008 and December 31, 2007, the percentage changes from the base
forecasted 12-month net interest income are within internal policy guidelines
and shows that interest rate risk was not overly significant at June 30,
2008.
 
 
 TABLE
6
 
 
 NORTHERN
STATES FINANCIAL CORPORATION
 EFFECT OF
INTEREST SHOCKS ON NET INTEREST INCOME
 as of
June 30, 2008 and December 31, 2007
 ($000s)
   Immediate
      Change in Rates-2.00
                  %
                  
                  
                  -1.00
                  %
                  
                  
                  +1.00
                  %
                  
                  
                  +2.00
                  %June
      30, 2008:Dollar
      Change from Base Forecast
                  
                  $
                  (580
                  )
                  
                  $
                  (181
                  )
                  
                  $
                  (7
                  )
                  
                  $
                  34Percent
      Change from Base Forecast
                  
                  
                  -2.69
                  %
                  
                  
                  -0.84
                  %
                  
                  
                  -0.03
                  %
                  
                  
                  0.16
                  %December
      31, 2007:Dollar
      Change from Base Forecast
                  
                  $
                  (222
                  )
                  
                  $
                  (137
                  )
                  
                  $
                  334
                  
                  
                  $
                  418Percent
      Change from Base Forecast
                  
                  
                  -1.10
                  %
                  
                  
                  -0.68
                  %
                  
                  
                  1.66
                  %
                  
                  
                  2.08
                  %
   23
 Table of Contents
 NORTHERN
STATES FINANCIAL CORPORATION
 ITEM 4.
CONTROLS AND PROCEDURES
  The
Company’s management has evaluated, with the participation of the Chairman of
the Board and President, and Vice President and Treasurer, the Company’s
disclosure controls and procedures (as such term is defined in Rule 13a – 15(e)
under the Securities Exchange Act of 1934) as of the end of the period covered
by this report.  Based on that evaluation, the Chairman of the Board
and President, and Vice President and Treasurer have concluded that these
controls and procedures were effective as of such date.  There were no
changes in internal control over financial reporting (as such term is defined in
Rule 13a – 15(f) under the Securities Exchange Act of 1934) that occurred during
the second quarter of 2008 that materially affected, or are reasonably likely to
materially affect, the Company’s internal control over financial
reporting.
 
 
 
 PART II.
OTHER INFORMATION
  
 ITEM
1.  LEGAL PROCEEDINGS
  From time
to time, due to the nature of its business, the Company and its subsidiaries are
often subject to various legal actions.  These legal actions, whether
pending or threatened, arise through the normal course of business and neither
the Company nor any of its subsidiaries are currently involved in any
proceedings that would, in management’s judgement, have a material adverse
effect on the Company’s business, results of operation, financial condition or
cash flows.
 
 
 
 ITEM
1A.  RISK FACTORS
  There
have been no material changes to the risk factors relating to the Company from
those risk factors previously disclosed in the Company’s Annual Report on Form
10-K for its fiscal year ended December 31, 2007 in response to Item 1A. to Part
I of Form 10-K.
 
  24
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
    ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
  Issuer
Purchases of Equity Securities
  The
following table sets forth information in connection with purchases made by, or
on behalf of, the Company of shares of the Company’s common stock during the
quarterly period ended June 30, 2008.
 
 Period
                  
                  Total
      Number
                    of
      Shares
                    Purchased
      (1)
                  
                  
                  Average
                    Price
      Paid
                    per
      Share
                  
                  
                  Total
      Number
                    of
      Shares Purchased
                    as
      Part of Publicly
                    Announced
      Plans
                  
                  
                  Maximum
      Number
                    of
      Shares that May
                    Yet
      be Purchased
                    under
      the PlansApril
      1, 2008 Through April 30, 2008
                  
                  
                  55,850
                  
                  
                  $
                  19.43
                  
                  
                  
                  0
                  
                  
                  
                  0May
      1, 2008 Through May 31, 2008
                  
                  
                  0
                  
                  
                  $
                  0.00
                  
                  
                  
                  0
                  
                  
                  
                  0June
      1, 2008 Through June 30, 2008
                  
                  
                  0
                  
                  
                  $
                  0.00
                  
                  
                  
                  0
                  
                  
                  
                  0Total
                  
                  
                  55,850
                  
                  
                  $
                  19.43
                  
                  
                  
                  0
                  
                  
                  
                  0
  (1)
                    On
      April 17, 2002, the Company's Board of Directors authorized the repurchase
      of up to 200,000 shares of the Company's common stock either in open
      market or private transactions.  On February 19, 2003, the
      Company's Board of Directors authorized the repurchase of an additional
      200,000 shares. (At June 30, 2008, these stock Repurchase Programs have
      been completed.)
  25
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
   ITEM
3.  DEFAULTS UPON SENIOR SECURITIES
  None
 
 ITEM
4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS
  The
annual meeting of stockholders of Northern States Financial Corporation was held
on May 22, 2008, with the stockholders of record at April 7, 2008 eligible to
vote in person or by proxy, with one vote for each share owned, to elect
directors for a one year term each and to ratify the appointment of Plante &
Moran, PLLC as independent auditors of the Company for the year ending December
31, 2008.  There were 4,128,105 shares of stock outstanding and
eligible to vote as of April 7, 2008.  The appointment of Plante &
Moran, PLLC as the Company’s independent auditors for the year ending December
31, 2008 was ratified by a vote
of 3,756,468 FOR ratification, with 900 shares voting AGAINST, and 9,537 shares
ABSTAINING.  The following directors were duly elected:
 
 Votes
                    FOR
                  Votes
                    WITHHELDFred
      Abdula
                  3,739,882
                  27,023Kenneth
      W. Balza
                  3,740,282
                  26,623Theodore
      A. Bertrand
                  3,740,582
                  26,323Jack
      H. Blumberg
                  3,724,547
                  42,358Frank
      J. Furlan
                  3,721,788
                  45,117Harry
      S. Gaples
                  3,729,517
                  37,388James
      A. Hollesteiner
                  3,684,517
                  82,388Allan
      J. Jacobs
                  3,740,282
                  26,623Raymond
      M. Mota
                  3,693,431
                  73,474Helen
      Rumsa
                  3,719,888
                  47,017
 
 
 
 ITEM
5.  OTHER INFORMATION
  None
 
  26
 Table of Contents
 
 NORTHERN STATES FINANCIAL
CORPORATION
  
 ITEM
6.  EXHIBITS
  (a)
                  Exhibits.
 
 Exhibit
3.1  Articles of Incorporation of the Company, as amended to date.
(Filed with Company’s annual report on Form 10-K for the year ended December 31,
1994 (Commission File 0-19300) and incorporated herein by
reference.)
 
 Exhibit
3.2  By-Laws of the Company, as amended and restated to date. (Filed
with Company’s quarterly report on Form 10-Q for the quarter ended March 31,
2004 (Commission File 0-19300) and incorporated herein by
reference.)
 
 Exhibit
4.1  Certain instruments defining the rights of holders of long-term
debt of the Company and certain of its subsidiaries, none of which authorize a
total amount of indebtedness in excess of 10% of the total assets of the Company
and its subsidiaries on a consolidated basis, have not been filed as
exhibits.  The Company hereby agrees to furnish a copy of any of these
agreements to the SEC upon request.
 
 Exhibit
31.1   Section 302  Certification of Chairman of the Board
and President.
 
 Exhibit
31.2   Section 302  Certification of Vice President and
Treasurer.
 
 Exhibit
32.1   Section 906   Certification.
 
  27
 Table of Contents
  
 NORTHERN STATES FINANCIAL
CORPORATION
 FORM
10-Q
 June 30,
2008
 
 
 
 SIGNATURES
 
 
 
 
 Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report on Form 10-Q to be signed on its behalf by the
undersigned hereunto duly authorized, on this 4th day of August
2008.
 
  NORTHERN STATES FINANCIAL
      CORPORATION(Registrant)Date: 
      August 4,
    2008
                        By:
                        /s/
      Fred AbdulaFred
      AbdulaChairman
      of the Boardof
      Directors and President
  Date: 
      August 4,
    2008
                      By:
                      /s/
      Thomas
      M. NemethThomas
      M. NemethVice
      President and Treasurer
 
  28
 Table of Contents
  
 NORTHERN STATES FINANCIAL
CORPORATION
 FORM
10-Q
 June 30,
2008
 
 
 
 
 EXHIBIT INDEX
 
 
 Exhibits
 
 
 Exhibit
3.1  Articles of Incorporation of the Company, as amended to date.
(Filed with Company’s annual report on Form 10-K for the year ended December 31,
1994 (Commission File 0-19300) and incorporated herein by
reference.)
 
 Exhibit
3.2  By-Laws of the Company, as amended and restated to date. (Filed
with Company’s quarterly report on Form 10-Q for the quarter ended March 31,
2004 (Commission File 0-19300) and incorporated herein by
reference.)
 
 Exhibit
4.1  Certain instruments defining the rights of holders of long-term
debt of the Company and certain of its subsidiaries, none of which authorize a
total amount of indebtedness in excess of 10% of the total assets of the Company
and its subsidiaries on a consolidated basis, have not been filed as
exhibits.  The Company hereby agrees to furnish a copy of any of these
agreements to the SEC upon request.
 
 Exhibit
31.1    Section 302    Certification of Chairman
of the Board and President.
 
 Exhibit
31.2    Section 302    Certification of Vice
President and Treasurer.
 
 Exhibit
32.1    Section 906   
 Certification.
 29