United
        States
 **SECURITIES
        AND EXCHANGE COMMISSION**
 Washington,
        D.C.   20549
 _________________________________________________________
 
 **FORM
        10-Q**
 
 **x     QUARTERLY
        REPORT PURSUANT TO SECTION 13 OR 15(d)**
 **OF
        THE SECURITIES EXCHANGE ACT OF 1934**
 For
        the
        quarterly period ended September 30, 2007
 OR
 **o      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
                  File
                    Number)
                (I.R.S.
                    Employer
                  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:  x          NO:
 o
 
 Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated filer, or a non-accelerated filer.  See definition of
“accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange
        Act.  (Check one):
 Large
        Accelerated Filer  oAccelerated
        Filer xNon-accelerated Filer  o
 
 Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Act).         
YES:  o         NO:  x
 
 
 4,178,105
        shares of common stock were outstanding
 as
        of
        November 2, 2007
 
 
 
 **NORTHERN
        STATES FINANCIAL CORPORATION AND SUBSIDIARY**
 **FORM
        10-Q**
 **For
        the Quarter Ended September 30, 2007**
 **INDEX**
   PART
                    I.
                FINANCIAL
                    INFORMATIONItem
                    1.
                Financial
                    Statements
                Page
                    NumberReport
                    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
                20Item
                    4.
                Controls
                    and Procedures
                22PART
                    II.
                OTHER
                    INFORMATIONItem
                    1.
                Legal
                    Proceedings
                23Item
                    1A.
                Risk
                    Factors
                24Item
                    2.
                Unregistered
                    Sales of Equity Securities and Use
                    of Proceeds
                24Item
                    3.
                Defaults
                    upon Senior Securities
                24Item
                    4.
                Submission
                    of Matters to a Vote of Security
                    Holders
                24Item
                    5.
                Other
                    Information
                24Item
                    6.
                Exhibits
                25Signatures
                
                26EXHIBIT
                    INDEX
                
                27
 1
 
 **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 September 30, 2007, the condensed
        consolidated statements of income for the three and nine month periods ended
        September 30, 2007 and 2006 and the condensed statements of cash flows and
        stockholders equity for the nine month periods ended September 30, 2007 and
        2006.  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,
        PLLC
 
 Chicago,
        Illinois
 October
        29, 2007
 
 2
  NORTHERN
                    STATES FINANCIAL CORPORATIONCONDENSED
                    CONSOLIDATED BALANCE
                    SHEETSSeptember
                    30, 2007 and December 31, 2006(In
                    thousands of dollars) (Unaudited)September
                    30,
                
                
                December
                    31,Assets
                
                2007
                
                
                2006Cash
                    and due from banks
                
                $
                13,340
                
                
                $
                19,023Interest
                    bearing deposits in financial institutions -maturities
                    less than 90 days
                
                
                179
                
                
                
                885Federal
                    funds sold
                
                
                4,025
                
                
                
                10,078Total
                    cash and cash equivalents
                
                
                17,544
                
                
                
                29,986Securities
                    available for sale
                
                
                205,433
                
                
                
                279,056Loans
                    and leases
                
                
                406,824
                
                
                
                373,715Less:
                    Allowance for loan and lease losses
                
                
                (4,112
                )
                
                
                (7,162
                )Loans
                    and leases, net
                
                
                402,712
                
                
                
                366,553Federal
                    Home Loan Bank stock
                
                
                1,445
                
                
                
                1,445Office
                    buildings and equipment, net
                
                
                9,275
                
                
                
                9,394Other
                    real estate owned
                
                
                2,857
                
                
                
                2,983Goodwill
                
                
                9,522
                
                
                
                9,522Core
                    deposit intangible asset
                
                
                1,507
                
                
                
                1,854Accrued
                    interest receivable and other assets
                
                
                7,303
                
                
                
                9,216Total
                    assets
                
                $
                657,598
                
                
                $
                710,009Liabilities
                    and Stockholders’ EquityLiabilitiesDepositsDemand
                    - noninterest bearing
                
                $
                55,948
                
                
                $
                58,530Interest
                    bearing
                
                
                435,207
                
                
                
                464,066Total
                    deposits
                
                
                491,155
                
                
                
                522,596Securities
                    sold under repurchase agreements
                
                
                72,453
                
                
                
                86,775Federal
                    funds purchased
                
                
                2,500
                
                
                
                0Federal
                    Home Loan Bank advances
                
                
                0
                
                
                
                11,500Subordinated
                    debentures
                
                
                10,000
                
                
                
                10,000Advances
                    from borrowers for taxes and insurance
                
                
                575
                
                
                
                794Accrued
                    interest payable and other liabilities
                
                
                7,499
                
                
                
                6,881Total
                    liabilities
                
                
                584,182
                
                
                
                638,546Stockholders’
                    EquityCommon
                    stock
                
                
                1,789
                
                
                
                1,789Additional
                    paid-in capital
                
                
                11,584
                
                
                
                11,584Retained
                    earnings
                
                
                67,298
                
                
                
                65,603Treasury
                    stock, at cost
                
                
                (7,202
                )
                
                
                (5,961
                )Accumulated
                    other comprehensive loss
                
                
                (53
                )
                
                
                (1,552
                )Total
                    stockholders’ equity
                
                
                73,416
                
                
                
                71,463Total
                    liabilities and stockholders’ equity
                
                $
                657,598
                
                
                $
                710,009The
                    accompanying notes are an integral part of these condensed consolidated
                    financial statements.
   3
  NORTHERN
                    STATES FINANCIAL CORPORATIONCONDENSED
                    CONSOLIDATED STATEMENTS OF INCOMEThree
                    and nine months ended September 30, 2007 and 2006(In
                    thousands of dollars, except per share data) (Unaudited)Three
                    months ended
                
                
                Nine
                    months endedSeptember
                    30,
                
                
                September
                      30,
                
                
                September
                      30,
                
                
                September
                      30,2007
                
                
                2006
                
                
                2007
                
                
                2006Interest
                    incomeLoans
                    (including fee income)
                
                $
                7,059
                
                
                $
                6,849
                
                
                $
                20,455
                
                
                $
                20,269SecuritiesTaxable
                
                
                2,283
                
                
                
                2,105
                
                
                
                7,262
                
                
                
                6,302Exempt
                    from federal income tax
                
                
                72
                
                
                
                56
                
                
                
                214
                
                
                
                170Commercial
                    paper - maturities less than 90 days
                
                
                0
                
                
                
                115
                
                
                
                0
                
                
                
                115Federal
                    funds sold and other
                
                
                271
                
                
                
                301
                
                
                
                751
                
                
                
                462Total
                    interest income
                
                
                9,685
                
                
                
                9,426
                
                
                
                28,682
                
                
                
                27,318Interest
                    expenseTime
                    deposits
                
                
                3,017
                
                
                
                3,272
                
                
                
                9,205
                
                
                
                9,086Other
                    deposits
                
                
                920
                
                
                
                1,059
                
                
                
                2,841
                
                
                
                3,061Repurchase
                    agreements and federal funds purchased
                
                
                809
                
                
                
                971
                
                
                
                2,720
                
                
                
                2,238Federal
                    Home Loan Bank advances
                
                
                28
                
                
                
                65
                
                
                
                205
                
                
                
                192Subordinated
                    debentures
                
                
                170
                
                
                
                170
                
                
                
                506
                
                
                
                490Total
                    interest expense
                
                
                4,944
                
                
                
                5,537
                
                
                
                15,477
                
                
                
                15,067Net
                    interest income
                
                
                4,741
                
                
                
                3,889
                
                
                
                13,205
                
                
                
                12,251Provision
                    for loan and lease losses
                
                
                967
                
                
                
                0
                
                
                
                (458
                )
                
                
                0Net
                    interest income after provision forloan
                    and lease losses
                
                
                3,774
                
                
                
                3,889
                
                
                
                13,663
                
                
                
                12,251Noninterest
                    incomeService
                    fees on deposits
                
                
                731
                
                
                
                620
                
                
                
                2,093
                
                
                
                1,844Trust
                    income
                
                
                184
                
                
                
                185
                
                
                
                611
                
                
                
                583Other
                    operating income
                
                
                305
                
                
                
                496
                
                
                
                1,092
                
                
                
                1,248Total
                    noninterest income
                
                
                1,220
                
                
                
                1,301
                
                
                
                3,796
                
                
                
                3,675Noninterest
                    expenseSalaries
                    and employee benefits
                
                
                2,097
                
                
                
                2,207
                
                
                
                6,546
                
                
                
                6,686Occupancy
                    and equipment, net
                
                
                548
                
                
                
                508
                
                
                
                1,791
                
                
                
                1,682Data
                    processing
                
                
                389
                
                
                
                395
                
                
                
                1,216
                
                
                
                1,190Legal
                
                
                149
                
                
                
                57
                
                
                
                371
                
                
                
                247Audit
                    and other professional
                
                
                333
                
                
                
                259
                
                
                
                917
                
                
                
                911Amortization
                    of core deposit intangible asset
                
                
                117
                
                
                
                117
                
                
                
                348
                
                
                
                348Printing
                    and supplies
                
                
                90
                
                
                
                85
                
                
                
                303
                
                
                
                324Other
                    operating expenses
                
                
                507
                
                
                
                562
                
                
                
                1,394
                
                
                
                1,612Total
                    noninterest expense
                
                
                4,230
                
                
                
                4,190
                
                
                
                12,886
                
                
                
                13,000Income
                    before income taxes
                
                
                764
                
                
                
                1,000
                
                
                
                4,573
                
                
                
                2,926Income
                    tax expense
                
                
                183
                
                
                
                279
                
                
                
                1,416
                
                
                
                750Net
                    income
                
                $
                581
                
                
                $
                721
                
                
                $
                3,157
                
                
                $
                2,176Earnings
                    per share
                
                $
                0.14
                
                
                $
                0.17
                
                
                $
                0.75
                
                
                $
                0.51Comprehensive
                    income
                
                $
                1,483
                
                
                $
                2,040
                
                
                $
                4,656
                
                
                $
                3,530The
                    accompanying notes are an integral part of these condensed consolidated
                    financial statements.






4




NORTHERN
                  STATES FINANCIAL CORPORATIONCONDENSED
                  CONSOLIDATED STATEMENTS OF CASH FLOWSNine
                  months ended September 30, 2007 and 2006(In
                  thousands of dollars) (Unaudited)Nine
                  months endedSeptember
                  30,
              
              
              September
                    30,2007
              
              
              2006Cash
                  flows from operating activitiesNet
                  income
              
              $
              3,157
              
              
              $
              2,176Adjustments
                  to reconcile net income to net cash fromoperating
                  activities:Depreciation
              
              
              435
              
              
              
              434(Gain)
                  Loss on sale of other real estate owned
              
              
              8
              
              
              
              (62
              )Provision
                  for loan and lease losses
              
              
              (458
              )
              
              
              0Amortization
                  of other intangible assets
              
              
              347
              
              
              
              347Net
                  change in accrued interest receivable and other assets
              
              
              993
              
              
              
              (889
              )Net
                  change in accrued interest payable and other liabilities
              
              
              (163
              )
              
              
              2,056Net
                  cash from operating activities
              
              
              4,319
              
              
              
              4,062Cash
                  flows from investing activitiesProceeds
                  from maturities and calls of securities available for sale
              
              
              167,078
              
              
              
              82,126Purchases
                  of securities available for sale
              
              
              (90,227
              )
              
              
              (67,346
              )Proceeds
                  from the redemption of Federal Home Loan Bank stock
              
              
              0
              
              
              
              439Change
                  in loans made to customers
              
              
              (35,729
              )
              
              
              16,104Proceeds
                  from sales of other real estate owned
              
              
              118
              
              
              
              1,542Property
                  and equipment expenditures
              
              
              (316
              )
              
              
              (492
              )Net
                  cash from investing activities
              
              
              40,924
              
              
              
              32,373Cash
                  flows from financing activitiesNet
                  increase (decrease) in:Deposits
              
              
              (31,441
              )
              
              
              (23,269
              )Securities
                  sold under repurchase agreementsand
                  federal funds purchased
              
              
              (11,822
              )
              
              
              9,601Advances
                  from borrowers for taxes and insurance
              
              
              (219
              )
              
              
              (361
              )Federal
                  Home Loan Bank advances
              
              
              10,000
              
              
              
              0Repayment
                  of Federal Home Loan Bank advances
              
              
              (21,500
              )
              
              
              0Purchase
                  of treasury stock
              
              
              (1,241
              )
              
              
              (252
              )Dividends
                  paid
              
              
              (1,462
              )
              
              
              (1,288
              )Net
                  cash used in financing activities
              
              
              (57,685
              )
              
              
              (15,569
              )Net
                  change in cash and cash equivalents
              
              
              (12,442
              )
              
              
              20,866Cash
                  and cash equivalents at beginning of period
              
              
              29,986
              
              
              
              29,668Cash
                  and cash equivalents at end of period
              
              $
              17,544
              
              
              $
              50,534The
                  accompanying notes are an integral part of these condensed consolidated
                  financial statements.






5




NORTHERN
                  STATES FINANCIAL CORPORATIONCONDENSED
                  CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITYNine
                  months ended Sepember 30, 2007 and 2006(In
                  thousands of dollars, except for per share data) (Unaudited)AccumulatedAdditional
              
              
              
              
              
              Other
              
              
              
              
              
              TotalCommon
              
              
              Paid-In
              
              
              Retained
              
              
              Comprehensive
              
              
              Treasury
              
              
              Stockholders’Stock
              
              
              Capital
              
              
              Earnings
              
              
              Loss
              
              
              Stock,
                  at Cost
              
              
              EquityBalance,
                  December 31, 2005
              
              $
              1,789
              
              
              $
              11,584
              
              
              $
              65,526
              
              
              $
              (3,487
              )
              
              $
              (4,660
              )
              
              $
              70,752Correction
                  of errors from previousyears,
                  January 1, 2006
              
              
              
              
              
              
              
              
              
              
              (245
              )
              
              
              
              
              
              
              
              
              
              
              (245
              )Balance,
                  January 1, 2006, restated
              
              
              1,789
              
              
              
              11,584
              
              
              
              65,281
              
              
              
              (3,487
              )
              
              
              (4,660
              )
              
              
              70,507Net
                  income
              
              
              
              
              
              
              
              
              
              
              2,176
              
              
              
              
              
              
              
              
              
              
              
              2,176Cash
                  dividends ($0.30 per share)
              
              
              
              
              
              
              
              
              
              
              (1,288
              )
              
              
              
              
              
              
              
              
              
              
              (1,288
              )Purchase
                  of 12,000 shares oftreasury
                  stock
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (252
              )
              
              
              (252
              )Unrealized
                  gain on securities availablefor
                  sale, net of deferred tax
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,354
              
              
              
              
              
              
              
              1,354Balance,
                  September 30, 2006
              
              $
              1,789
              
              
              $
              11,584
              
              
              $
              66,169
              
              
              $
              (2,133
              )
              
              $
              (4,912
              )
              
              $
              72,497Balance,
                  December 31, 2006
              
              $
              1,789
              
              
              $
              11,584
              
              
              $
              65,603
              
              
              $
              (1,552
              )
              
              $
              (5,961
              )
              
              $
              71,463Net
                  income
              
              
              
              
              
              
              
              
              
              
              3,157
              
              
              
              
              
              
              
              
              
              
              
              3,157Cash
                  dividends ($0.35 per share)
              
              
              
              
              
              
              
              
              
              
              (1,462
              )
              
              
              
              
              
              
              
              
              
              
              (1,462
              )Purchase
                  of 55,000 shares oftreasury
                  stock
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (1,241
              )
              
              
              (1,241
              )Unrealized
                  gain on securities availablefor
                  sale, net of deferred tax
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,499
              
              
              
              
              
              
              
              1,499Balance,
                  September 30, 2007
              
              $
              1,789
              
              
              $
              11,584
              
              
              $
              67,298
              
              
              $
              (53
              )
              
              $
              (7,202
              )
              
              $
              73,416The
                  accompanying notes are an integral part of these condensed consolidated
                  financial statements.






6




**NORTHERN
          STATES FINANCIAL CORPORATION**
 
 **NOTES
          TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 
 For
          the
          Quarter Ended September 30, 2007
 
 (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.
 
 The
        following unaudited condensed
        financial statements have been prepared pursuant to the rules and regulation
        of
        the Securities and Exchange Commission.  Certain information and note
        disclosures normally included in annual financial statements prepared in
        accordance with generally accepted accounting principles have been condensed
        or
        omitted pursuant to those rules and regulations, although the Company believes
        that the disclosures made are adequate to make the information not
        misleading.
 
 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, 2006 and 2005.  The results
        of operations for the three and nine month period ended September 30, 2007,
        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 nine months of 2007 and the entire year of 2006.  The
        average outstanding common shares used for earnings per share
        follows:
  **Three
                    months ended**
                ****
                ****
                **Nine months
                    ended****Sep. 30,**
                ****
                ****
                **Sep.
                    30,**
                ****
                ****
                **Sep.
                    30,**
                ****
                ****
                **Sep.
                    30,**
                ********
                ****
                **2007**
                ****
                ****
                **2006**
                ****
                ****
                **2007**
                ****
                ****
                **2006**Average
                    outstanding common shares
                
                
                4,178,105
                
                
                
                4,283,105
                
                
                
                4,193,013
                
                
                
                4,290,094
 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
   7
  **NORTHERN
            STATES FINANCIAL CORPORATION**
 
 **NOTES
            TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 
 For
            the
            Quarter Ended September 30, 2007
 
 (Unaudited)
 additional
        shares of its stock.  During the three months ended March 31, 2007,
        30,000 shares of stock were repurchased for a total of $650,000 and during
        the
        three months ended June 30, 2007, 25,000 shares of stock were purchased for
        $591,000.  No shares were repurchased during the three months ended
        September 30, 2007.   At September 30, 2007, the Company had a
        total of 294,150 shares of treasury stock that it purchased under these
        programs.  Treasury stock is carried at cost.  The Company
        may purchase 105,850 shares under the remaining stock repurchase
        program.
 
 Information
        related to common stock was as follows:
  **September 30,**
                ****
                ****
                **December
                    31,**
                ********
                ****
                **2007**
                ****
                ****
                **2006**Par
                    value per share
                
                $
                0.40
                
                
                $
                0.40Authorized
                    shares
                
                
                6,500,000
                
                
                
                6,500,000Issued
                    shares
                
                
                4,472,255
                
                
                
                4,472,255Treasury
                    shares
                
                
                294,150
                
                
                
                239,150Outstanding
                    shares
                
                
                4,178,105
                
                
                
                4,233,105
 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,
        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
        6.84019% at September 30, 2007 and is the effective rate from September 17,
        2007
        through December 16, 2007.  For the three and nine months ended
        September 30, 2007, interest expense on the subordinated debentures was $170,000
        and $506,000.  For the three and nine months ended September 30, 2006,
        interest expense on the subordinated debentures was $170,000 and
        $490,000.
 
 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
  **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 September 30, 2007 and the consolidated results of operations for
        the three and nine month periods ended September 30, 2007, compared with
        the
        same periods of 2006.  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.
 
 It
        should
        be noted that the Bank’s former wholly owned subsidiary, Waukegan Hotels, LLC
        (“WHLLC”) mentioned in previous filings was dissolved during the second quarter,
        2007.  The Bank formed WHLLC in 2006 in order to operate two motels
        that had been foreclosed upon and were being carried as other real estate
        owned.  These properties were sold in the fourth quarter of 2006 and
        all operations were completed in the first quarter of 2007.
  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 September 30, 2007 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, uncertainty regarding the Company’s ability to ultimately recover on
        the surety bonds relating to the remaining equipment lease pools and other
        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 and deposit 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 September 30, 2007 declined from year-end levels.  Assets
        totaled $657.6 million at September 30, 2007, decreasing $52.4 million or
        7.4
        percent from total assets of $710.0 million at December 31, 2006 as the Company
        restructured its balance sheet to improve earnings.  The restructuring
        included a decrease to federal funds sold of $6.1 million and to the securities
        portfolio of  $73.6 million since December 31, 2006 primarily due to
        maturities of lower yielding U.S. government-sponsored agency
        securities.  The Company primarily redeployed the liquidity made
        available from the federal funds sold and securities maturing during the
        quarter
        into higher yielding loans and leases, which increased $33.1 million from
        December 31, 2006.  The increase in loans resulted from marketing
        efforts made by our loan staff and from borrowers drawing on existing lines
        of
        credit.  The balance of the proceeds from the matured securities was
        redeployed to redeem higher cost interest-bearing deposits and
        borrowings.  Interest-bearing deposits
   9
  decreased
        by $28.9 million since year-end and borrowings in the form of securities
        sold
        under repurchase agreements and Federal Home Loan Bank term advances were
        reduced $14.3 million and $11.5 million since December 31, 2006,
        respectively.
 
 Earnings
        for the third quarter 2007 were $581,000 or $.14 per share as compared with
        $721,000 or $.17 per share for the same quarter last year.  Third
        quarter 2007 earnings decreased as a result of a provision to the allowance
        for
        loan and lease losses for the quarter of $967,000 due to concerns over the
        weakening economy and its affect on the Company’s growing loan
        portfolio.  Loan growth of $33.1 million since December 31, 2006 and
        net charge-offs of nonperforming loans contributed to the decision to increase
        the provision.  During the same quarter last year, the Company
        determined that no provision was necessary to the allowance for loan and
        lease
        losses.
 
 During
        the third quarter of 2007, net interest income (interest income less interest
        expense) continued to improve, increasing $852,000 over the same three months
        last year.  The growth to net interest income is attributable to the
        Company’s reduction of its lower-earning U.S. government-sponsored securities
        portfolio and decreases to its higher cost interest-bearing deposits and
        securities sold under repurchase agreements since the beginning of the
        year.  Noninterest income decreased $81,000 during the third quarter
        of 2007 as the Company had no sales of other real estate owned during the
        three
        months ended September 30, 2007 while it recognized a gain of $80,000 on
        the
        sale of other real estate owned during the third quarter of
        2006.  Noninterest expenses also increased $40,000 during the third
        quarter of 2007 as the result of increased legal fees and audit and professional
        fees compared to the same quarter last year.
 
 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 September 30, 2007 is
        adequate to cover probable incurred credit losses.
  One
          of the components used to measure
          the adequacy of the allowance for loan losses is historical loss
          experience.  In developing its analysis, management considers that
          different loan classifications within the portfolio have different loss
          experience ratios.  For example, loans secured by real estate
          generally experience lower loss experience than loans secured by other
          assets.  As of September 30, 2007, approximately 86 percent of the
          Bank’s loans are secured by real estate.
   10
  Management
            specifically analyzes its
            impaired loans for probable losses.  The change in the volume of
            impaired loans may significantly impact the amount of estimated losses
            specifically allocated to these loans.  The amount of the specific
            allocation is dependent 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
            subject
            to greater fluctuation than an allocation for a pool of loans based on
            historical loss trends.  The amount of the allocations on impaired
            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 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
 
 During
        2007, management has concentrated on increasing the Company’s net interest
        income.  To this end, management has restructured the Company’s
        balance sheet.  The Company’s federal funds sold at September 30, 2007
        decreased to $4.0 million from $10.1 million at December 31, 2006, with the
        liquidity provided used to partially fund increases in the Company’s loan
        portfolio, which grew $33.1 million from year-end.
 
 Securities
        available for sale were reduced $73.6 million from December 31,
        2006.  The reduction came mainly from maturities and calls of U.S.
        government-sponsored agency securities, which decreased $123.5 million from
        year-end while the carrying value of mortgage-backed securities increased
        $45.5
        million.  The maturity of lower earning U.S. government-sponsored
        agency securities has increased the yield on the remaining U.S.
        government-sponsored agency securities portfolio to 4.46 percent at September
        30, 2007 compared with 3.63 percent at December 31, 2006.  The Company
        has U.S. government-sponsored entity securities with a carrying amount of
        $42.4
        million that yield 3.21 percent that will be maturing during the fourth quarter
        of 2007.  As these lower yielding U.S. government-sponsored entity
        securities mature during the next three months, the Company has the opportunity
        to use the funds to either fund loan growth, replace them with higher yielding
        securities or to lower the amounts of higher cost borrowings or interest-bearing
        deposits carried on its balance sheet.  It should be noted that the
        Company has U.S. government-sponsored entity securities with a carrying amount
        of $120.4 million with call provisions at September 30, 2007.  If
        interest rates should decline it is possible that a portion of these U.S.
        government-sponsored agency securities will be called and the yields earned
        on
        the securities portfolio may decrease as a consequence.
 
 Effective
        July 1, 2007, the Company has entered into a contractual arrangement with
        First
        Tennessee Bank NA (“FTN”) to provide advisory services to management pertaining
        to the administration of the Company’s securities portfolio.  The
        purpose of this engagement is to assist the Company in its goal of increasing
        the yields earned on its securities portfolio.  During the third
        quarter the Company has increased the yield on its securities portfolio to
        4.96
        percent at September 30, 2007 as compared with 3.80 percent at December 31,
        2006.
 
 Loans
        and
        leases are the largest earning asset of the Company and totaled $406.8 million
        at September 30, 2007, increasing $33.1 million from $373.7 million at December
        31, 2006.  The increase in loans and leases was due to the marketing
        efforts of the loan staff as well as draws made by borrowers on existing
        credit
        lines.  Construction loans increased $17.8 million and real estate
        loans secured by commercial properties increased $13.1
        million.  Approximately 86 percent of the Bank’s loan portfolio at
        September 30, 2007 was secured by real estate.  On September 18, 2007
        the prime rate was reduced 50 basis points from 8.25 percent to 7.75 percent
        that affected approximately $115 million in variable rate
   11
  loans.  If
        further rate decreases are perceived, variable rate loans may become more
        popular with borrowers.   Loan commitments have increased $32.0
        million to $137.5 million at September 30, 2007 compared with $105.5 million
        at
        December 31, 2006.  Letters of credit also increased at September 30,
        2007 to $11.4 million from $8.0 million at year-end.  At September 30,
        2007, loans to related parties totaled $1.5 million.  Loan commitments
        and letters of credit issued to related parties were $1.9 million at September
        30, 2007.  Loans, loan commitments and letters of credit to related
        parties are made at the same terms and conditions that are available to the
        public.
 
 Deposits
        decreased $31.4 million, or 6.0 percent, from year-end 2006.  A
        majority of the decline in deposits resulted from decreases to higher cost
        money
        market accounts and time deposits of $100,000 or greater, which decreased
        $8.1
        million and $9.4 million, respectively.  Demand, NOW and savings
        accounts also declined $2.6 million, $4.9 million and $5.3 million from December
        31, 2006, respectively.  Time deposits under $100,000 also decreased
        $1.1 million from year-end.  Most of the decrease to money market
        accounts came from commercial depositors who used the withdrawn funds for
        business purposes or transferred the funds to alternative investments outside
        of
        the Bank.
 
 The
        Company, as the result of management’s efforts in restructuring the balance
        sheet, has carefully reviewed the Bank’s deposit products and the rates paid on
        those products.  In order to increase its net interest income and in
        response to the recent lowering of the prime lending rate by 50 basis points,
        the Bank reduced rates paid on its deposit products.  At September 30,
        2007, rates offered on time deposits of $100,000 or greater have declined
        65 to
        85 basis points from year-end 2006.  On money market deposits the Bank
        has lowered its highest tier by 85 basis points since December 31,
        2006.  NOW account deposit rates have decreased 25 basis points since
        the end of last year.  Some of the reduction to deposit balances from
        December 31, 2006 can be attributed to these rate reductions.
 
 Brokered
        deposits totaled $44.2 million at September 30, 2007, which approximate year-end
        levels.  Brokered deposits are time deposits placed in the Bank by a
        broker from depositors outside the Bank’s geographic area.  These
        deposits usually bear an interest rate of 10 to 15 basis points greater than
        the
        terms and conditions offered to local depositors.  During the next
        twelve months the Company has scheduled maturities of $23.3 million in brokered
        deposits that have a blended rate of 4.75 percent.  The Company
        expects to use proceeds from upcoming maturities of lower yielding U.S.
        government-sponsored entity securities to provide the liquidity to lower
        the
        amount of its brokered deposits as these deposits mature.
 
 Securities
        sold under repurchase agreements decreased by $14.3 million to $72.5 million
        at
        September 30, 2007 from $86.8 million at December 31, 2006.  At
        September 30, 2007 the Company had no Federal Home Loan Bank term advances
        as
        compared with $11.5 million at year-end.  The Company reduced its
        repurchase agreements and term advance borrowings as higher rates are usually
        paid on these other borrowings than on deposits.  It is expected that
        higher cost securities sold under repurchase agreements will decrease further
        in
        2007.
 
 As
        previously disclosed, included in
        other liabilities at September 30, 2007 is $304,000 related to estimated
        environmental clean-up expenses of a parcel of other real estate owned, which
        had been sold in previous years.  The Company intends to seek
        reimbursement of these expenses from the State of Illinois that has an
        established fund for this type of cleanup.  However, there can be no
        assurance that the Company will be successful in obtaining any such
        reimbursement.
 
 CAPITAL
 
 Total
        stockholders’ equity was $73.4 million at September 30, 2007, increasing $2.0
        million from year-end 2006.  During the nine months ended September
        30, 2007 there were increases to stockholder’s equity from net income of
        $3,157,000 and from a $1,499,000 adjustment for the change in he unrealized
        loss
        on securities available for sale, net of deferred tax.  Stockholders’
equity was decreased during the first nine months of 2007 as a result of
        the
        purchase of 55,000 shares of treasury stock for a total amount of
   12
  $1,241,000
        and by the payment of a cash dividend of $.35 per share that totaled
        $1,462,000.  The book value of the Company’s stock at September 30,
        2007 was $17.57 per share.
 
 On
        a
        consolidated basis, the Company’s Tier 1 to total average assets ratio and total
        capital to assets ratio, on a risk adjusted basis, were 11.21 percent and
        15.14
        percent, respectively, as of September 30, 2007, and exceed the regulatory
        minimum for capital adequacy purposes.  Management believes that the
        capital position of both the Company and the Bank are adequate 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
        deposits, 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.  The Bank’s liquid assets totaled $86.1 million at
        September 30, 2007.  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.
 
 Management
        reviews the liquidity ratio of the Bank monthly.  The liquidity ratio
        is the net liquid assets divided by net deposits and short-term
        liabilities.  At September 30, 2007, this ratio at the Bank was 19.6
        percent and was within management’s internal policy guidelines.
 
 Liquidity
        management involves the Company’s ability to meet the cash flow requirements of
        its customers.  The Company needs to have sufficient cash flow to meet
        the requirements of depositors wanting to withdraw funds or to fund loans
        to
        borrowers.  The statements of cash flows shows that for the nine
        months ended September 30, 2007 cash and cash equivalents were $17.5 million
        decreasing $12.4 million from December 31, 2006.
 
 Federal
        funds sold, interest bearing deposits in banks and available for sale
        securities, particularly those of shorter maturities, are principal sources
        of
        liquidity.  Federal funds sold at September 30, 2007 were $4.0
        million.  The liquidity provided by the decrease in federal funds sold
        was used to partially fund the loan growth of $33.1 million since
        year-end.  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 or public time deposits of $100,000 or greater
        that often require the pledging of securities.  Securities available
        for sale totaled $205.4 million at September 30, 2007 of which $131.4 million
        were pledged to secure public deposits and repurchase agreements.
 
 During
        the first nine months of 2007, the Company had incoming cash flows from
        maturities and calls of securities available for sale of $167.1 million while
        it
        had cash outflows for purchases of securities of $90.2 million.  These
        securities activities during this period of 2007 provided liquidity of $76.9
        million.  This liquidity was used to restructure the liability
        components of the Company’s balance sheet such as deposits, repurchased
        agreements and Federal Home Loan Bank term advance borrowings that decreased
        by
        $31.4 million, $14.3 million and $11.5 million, respectively, with the balance
        of the liquidity used to fund loan growth.
  Other
        sources of liquidity available to the Company are deposits and
        borrowings.  The Company may use brokered deposits as a source of
        liquidity.  At September 30, 2007, the Company had drawn $2.5 million
        on its federal funds purchased arrangement from an independent bank. The
        Company
        has $22.5 million remaining available through this arrangement at September
        30,
        2007.  The Company has an
   13
  additional
        $8.6 million available for short term borrowings from the Federal Home Loan
        Bank
        for liquidity purposes.
 
 RESULTS
        OF OPERATIONS
 
 NET
        INCOME
  Consolidated
        net income for the quarter ended September 30, 2007 was $581,000, decreasing
        $140,000 compared with net income of $721,000 for the same quarter of
        2006.  The annualized return on average assets was .35 percent for the
        quarter, decreasing from .40 percent for the same quarter the previous
        year.  Although net interest income increased by $852,000 during the
        quarter, the concern over the weakening economy and its affect on the Company’s
        growing loan portfolio and the level of net charge-offs induced management
        to
        make a provision to the allowance for loan and lease losses for the quarter
        of
        $967,000.  During the same quarter last year, the Company determined
        that no provision was necessary.  Net income for the quarter was also
        affected by decreases to nonintinerest income of $81,000 and increases to
        noninterest expenses of $40,000.
 
 For
        the
        nine months ended September 30, 2007, net income was $3,157,000 as compared
        with
        $2,176,000 for the first nine months of 2006.  The annualized return
        on average assets for the first nine months of 2007 was .62 percent increasing
        from .41percent for the same period of 2006.  The increase to net
        income for the first nine months of 2007 is primarily the result of the
        Company’s improved net interest income that was $954,000 above net interest
        income for the same nine months of 2006.  Also contributing to the
        increase to net income was the net reduction of $458,000 to the provision
        for
        loan and leases loss expense.
 
 NET
        INTEREST INCOME
  Net
        interest income, the difference between interest income on earning assets
        and
        interest expense on interest bearing liabilities, increased $852,000 to $4.7
        million during the three months ended September 30, 2007 compared with $3.9
        million for the same quarter of 2006.  Net interest income during the
        third quarter of 2007 grew as yields earned on its loans and taxable securities
        increased while rates paid for deposits and borrowings remained
        stable.  Table 1 shows that the average yield on loans was 7.26
        percent for the three months ended September 30, 2007 as compared with 7.02
        percent for the same period of 2006, an increase of 24 basis
        points.  The yield on taxable securities increased even more
        significantly during the quarter to 4.60 percent compared with 3.39 percent
        for
        the same quarter last year, an increase of 121 basis points.  The
        increase to taxable securities yields during the third quarter of 2007 was
        due
        to maturities of approximately $137.0 million of U.S. government-sponsored
        entity securities having an average yield of 3.04 percent during the first
        nine
        months of 2007.  The Company was able to purchase new securities that
        earn higher yields or use the funds provided by the maturities to make loans
        or
        lower interest bearing deposits and borrowings.  Rates on interest
        bearing liabilities remained stable at 3.81 percent for the quarter ended
        September 30, 2007 compared to the 3.83 percent for the same quarter of
        2006.
 
 The
        Company has taken steps to increase
        its net interest income by constantly reviewing its deposit rates and adjusting
        them if appropriate.  To date in 2007, the Company has lowered the
        rates offered on its time deposits by 65 to 85 basis points.  Although
        lowering rates paid on deposit products may result in some decreases in deposit
        balances, the Company believes this strategy will ultimately result in increased
        net interest income and profitability.  The Company expects to
        decreased its levels of higher cost brokered deposits as these deposits
        mature.  At September 30, 2007, there is $23.3 million of brokered
        deposits, currently being paid an average of 4.75 percent, scheduled to mature
        within the next 12 months.
 
 14
  TABLE
        1
 NORTHERN
        STATES FINANCIAL CORPORATION
 ANALYSIS
        OF AVERAGE BALANCE AND TAX EQUIVALENT
        RATES
 For
          the
          Three Months Ended  September 30, 2007 and 2006 - Rates are
          Annualized
 ($
          000s)
  2007
              
              
              2006Average
              
              
              
              
              
              
              
              
              AverageBalance
              
              
              Interest
              
              
              Rate
              
              
              Balance
              
              
              Interest
              
              
              RateAssetsLoans
                  (1)(2)(3)
              
              $
              390,223
              
              
              $
              7,081
              
              
              
              7.26
              %
              
              $
              390,944
              
              
              $
              6,864
              
              
              
              7.02
              %Taxable
                  securities (4)
              
              
              197,623
              
              
              
              2,283
              
              
              
              4.60
              %
              
              
              243,661
              
              
              
              2,105
              
              
              
              3.39
              %Tax
                  advantaged securities (2) (4)
              
              
              7,684
              
              
              
              109
              
              
              
              5.66
              %
              
              
              6,226
              
              
              
              84
              
              
              
              5.37
              %Commercial
                  paper - maturitiesless
                  than 90 days
              
              
              0
              
              
              
              0
              
              
              
              0.00
              %
              
              
              8,454
              
              
              
              115
              
              
              
              5.44
              %Federal
                  funds sold
              
              
              21,496
              
              
              
              271
              
              
              
              5.04
              %
              
              
              22,097
              
              
              
              301
              
              
              
              5.45
              %Interest
                  earning assets
              
              
              617,026
              
              
              
              9,744
              
              
              
              6.31
              %
              
              
              671,382
              
              
              
              9,469
              
              
              
              5.60
              %Noninterest
                  earning assets
              
              
              39,539
              
              
              
              
              
              
              
              
              
              
              
              44,649Average
                  assets
              
              $
              656,565
              
              
              
              
              
              
              
              
              
              
              $
              716,031Liabilities
                  and stockholders' equityequityNOW
                  deposits
              
              $
              46,447
              
              
              $
              101
              
              
              
              0.87
              %
              
              $
              51,857
              
              
              $
              120
              
              
              
              0.93
              %Money
                  market deposits
              
              
              75,873
              
              
              
              696
              
              
              
              3.67
              %
              
              
              73,976
              
              
              
              765
              
              
              
              4.14
              %Savings
                  deposits
              
              
              64,523
              
              
              
              123
              
              
              
              0.76
              %
              
              
              74,397
              
              
              
              174
              
              
              
              0.94
              %Time
                  deposits
              
              
              248,264
              
              
              
              3,017
              
              
              
              4.86
              %
              
              
              283,791
              
              
              
              3,272
              
              
              
              4.61
              %Other
                  borrowings
              
              
              83,715
              
              
              
              1,007
              
              
              
              4.81
              %
              
              
              94,908
              
              
              
              1,206
              
              
              
              5.08
              %Interest
                  bearing liabilities
              
              
              518,822
              
              
              
              4,944
              
              
              
              3.81
              %
              
              
              578,929
              
              
              
              5,537
              
              
              
              3.83
              %Demand
                  deposits
              
              
              57,308
              
              
              
              
              
              
              
              
              
              
              
              57,669Other
                  noninterest bearing liabilities
              
              
              7,589
              
              
              
              
              
              
              
              
              
              
              
              7,998Stockholders'
                  equity
              
              
              72,846
              
              
              
              
              
              
              
              
              
              
              
              71,435Average
                  liabilities andstockholders'
                  equity
              
              $
              656,565
              
              
              
              
              
              
              
              
              
              
              $
              716,031Net
                  interest income
              
              
              
              
              
              $
              4,800
              
              
              
              
              
              
              
              
              
              
              $
              3,932Net
                  interest spread
              
              
              
              
              
              
              
              
              
              
              2.50
              %
              
              
              
              
              
              
              
              
              
              
              1.77
              %Net
                  yield on interest earning
                assets
                  (4)
              
              
              
              
              
              
              
              
              
              
              3.11
              %
              
              
              
              
              
              
              
              
              
              
              2.33
              %Interest-bearing
                  liabilitiesto
                  earning assets ratio
              
              
              
              
              
              
              
              
              
              
              84.08
              %
              
              
              
              
              
              
              
              
              
              
              86.23
              %
   (1)
                  -
              Interest
                  income on loans includes loan origination and other fees of $71
                  and $62
                  for the three months ended September 30, 2007 and
                  2006.
 (2)
                  -
              Tax-exempt
                  income is reflected on a fully tax equivalent basis utilizing a
                  34% tax
                  rate.
 (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 September 30, 2007 and 2006
                  average balance information includes an average unrealized gain
                  (loss) for
                  taxable securities of ($790) and ($4,871) and for tax-advantaged
                  securities of ($20) and
                  ($29).






15




TABLE
        2
 NORTHERN
        STATES FINANCIAL CORPORATION
 ANALYSIS
        OF AVERAGE BALANCE AND TAX EQUIVALENT
        RATES
 For
          the Nine Months Ended  September 30, 2007 and 2006 - Rates are
          Annualized
 ($
          000s)


2007
              
              
              2006Average
              
              
              
              
              
              
              
              
              AverageBalance
              
              
              Interest
              
              
              Rate
              
              
              Balance
              
              
              Interest
              
              
              RateAssetsLoans
                  (1)(2)(3)
              
              $
              379,307
              
              
              $
              20,512
              
              
              
              7.21
              %
              
              $
              392,800
              
              
              $
              20,314
              
              
              
              6.90
              %Taxable
                  securities (4)
              
              
              227,445
              
              
              
              7,262
              
              
              
              4.23
              %
              
              
              248,411
              
              
              
              6,302
              
              
              
              3.31
              %Tax
                  advantaged securities (2) (4)
              
              
              7,702
              
              
              
              324
              
              
              
              5.60
              %
              
              
              6,326
              
              
              
              258
              
              
              
              5.42
              %Commercial
                  paper - maturitiesless
                  than 90 days
              
              
              0
              
              
              
              0
              
              
              
              0.00
              %
              
              
              2,818
              
              
              
              115
              
              
              
              5.44
              %Federal
                  funds sold
              
              
              18,660
              
              
              
              751
              
              
              
              5.37
              %
              
              
              11,883
              
              
              
              462
              
              
              
              5.18
              %Interest
                  earning assets
              
              
              633,114
              
              
              
              28,849
              
              
              
              6.06
              %
              
              
              662,238
              
              
              
              27,451
              
              
              
              5.48
              %Noninterest
                  earning assets
              
              
              41,031
              
              
              
              
              
              
              
              
              
              
              
              44,871Average
                  assets
              
              $
              674,145
              
              
              
              
              
              
              
              
              
              
              $
              707,109Liabilities
                  and stockholders' equityequityNOW
                  deposits
              
              $
              48,555
              
              
              $
              299
              
              
              
              0.82
              %
              
              $
              53,263
              
              
              $
              393
              
              
              
              0.98
              %Money
                  market deposits
              
              
              76,373
              
              
              
              2,168
              
              
              
              3.78
              %
              
              
              73,142
              
              
              
              2,079
              
              
              
              3.79
              %Savings
                  deposits
              
              
              66,259
              
              
              
              374
              
              
              
              0.75
              %
              
              
              76,535
              
              
              
              589
              
              
              
              1.03
              %Time
                  deposits
              
              
              253,906
              
              
              
              9,205
              
              
              
              4.83
              %
              
              
              283,369
              
              
              
              9,086
              
              
              
              4.28
              %Other
                  borrowings
              
              
              92,497
              
              
              
              3,431
              
              
              
              4.95
              %
              
              
              83,378
              
              
              
              2,920
              
              
              
              4.67
              %Interest
                  bearing liabilities
              
              
              537,590
              
              
              
              15,477
              
              
              
              3.84
              %
              
              
              569,687
              
              
              
              15,067
              
              
              
              3.53
              %Demand
                  deposits
              
              
              56,750
              
              
              
              
              
              
              
              
              
              
              
              58,501Other
                  noninterest bearing liabilities
              
              
              7,761
              
              
              
              
              
              
              
              
              
              
              
              7,708Stockholders'
                  equity
              
              
              72,044
              
              
              
              
              
              
              
              
              
              
              
              71,213Average
                  liabilities andstockholders'
                  equity
              
              $
              674,145
              
              
              
              
              
              
              
              
              
              
              $
              707,109Net
                  interest income
              
              
              
              
              
              $
              13,372
              
              
              
              
              
              
              
              
              
              
              $
              12,384Net
                  interest spread
              
              
              
              
              
              
              
              
              
              
              2.22
              %
              
              
              
              
              
              
              
              
              
              
              1.95
              %Net
                  yield on interest earning assets
                  (4)
              
              
              
              
              
              
              
              
              
              
              2.81
              %
              
              
              
              
              
              
              
              
              
              
              2.47
              %Interest-bearing
                  liabilitiesto
                  earning assets ratio
              
              
              
              
              
              
              
              
              
              
              84.91
              %
              
              
              
              
              
              
              
              
              
              
              86.02
              %
   (1)
                    -
                Interest
                    income on loans includes loan origination and other fees of $327
                    and $296
                    for the nine months ended September 30, 2007 and 2006.(2)
                    -
                Tax-exempt
                    income is reflected on a fully tax equivalent basis utilizing
                    a 34% tax
                    rate.(3)
                    -
                Non-accrual
                    loans are included in average loans.(4)
                    -
                Rate
                    information was calculated on the average amortized cost for
                    securities.  The nine months ended September 30, 2007 and 2006
                    average balance information includes an average unrealized gain
                    (loss) for
                    taxable securities of ($1,434) and ($5,237) and for tax-advantaged
                    securities of ($6) and ($25).
   16
  Table
        2
        shows that during the nine months ended September 30, 2007, net interest
        income
        on a fully tax equivalent basis increased $988,000 compared with the same
        period
        of 2006.  The increase to net interest income was brought about by
        growth in yields earned on loans, taxable securities and federal funds sold
        that
        increased to a greater extent than growth in rates paid on interest bearing
        liabilities.   Table 2 shows that average yields on interest
        earning assets increased 58 basis points during the nine months ended September
        30, 2007 as compared with the same period last year while average rates paid
        on
        interest bearing liabilities increased by only 31 basis points.
 
 ASSET
        QUALITY AND THE PROVISION FOR LOAN AND LEASE LOSSES
 
 At
        September 30, 2007, 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 the current allowance of $4.1 million was adequate to cover probable
        incurred loan and lease losses.  At September 30, 2007, the allowance
        decreased by $3.1 million from the year-end 2006 allowance of $7.2
        million.  During the first nine months of 2007, $2.6 million in loans
        and leases were charged off against the allowance compared with charge-offs
        of
        $3.1 million during the same period last year.  There was $50,000 in
        recoveries of loans previously charged off during the nine months ended
        September 30, 2007 compared with $36,000 in recoveries during the same period
        in
        2006.  During the nine months ended September 30, 2007, there was a
        negative provision for loan and lease losses of $458,000 compared to no
        provision during the same period of 2006.
 
 During
        the third quarter of 2007, concern over the weakening economy and its affect
        on
        the Company’s growing loan portfolio induced management to make a provision to
        the allowance for loan and lease losses for the quarter of
        $967,000.  Loan growth of $33.1 million since December 31, 2006 and
        the charging-off of $585,000 of nonperforming loans during the third quarter
        of
        2007 also contributed to this decision to increase the allowance.
 
 During
        the first quarter of 2007, the Company reduced its allowance for loan and
        lease
        loss and booked a negative provision for loan and lease losses by $1.4 million.
        This reduction occurred as the Company significantly reduced its nonperforming
        loans from year-end 2006 and found that some allocations of the allowance
        were
        no longer necessary.
  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, totaled $6.7 million at September 30, 2007, or 1.64 percent of
        total
        loans and leases, as compared with $8.2 million at December 31, 2006, or
        2.19
        percent of loans and leases.   The reduction to nonperforming
        loans at September 30, 2007 compared to year-end was $1.5 million or
        approximately 19 percent.
 
 The
        Company previously disclosed its involvement in certain lease pools purchased
        in
        2000 and 2001 from Commercial Money Center (“CMC”).  At September 30,
        2007, the nonaccrual lease pools had a carrying value of  $2.0 million
        and are secured by surety bonds issued by RLI Insurance Company. The lease
        pools
        balances of $4.0 million at December 31, 2006 were reduced during the first
        quarter of 2007 to $2.0 million as $2.0 million of the lease pools were charged
        off against the allowance for loan and lease losses.  The Company
        continues its litigation against RLI Insurance Company seeking performance
        under
        the terms of the surety bonds.
 
 Also
        on
        nonaccrual status at September 30, 2007 is a $1.5 million loan for a 90-unit
        condominium construction project which has been classified as a nonaccrual
        loan
        since December 31, 2003.  The Company participated in this 90-unit
        condominium construction project with other financial institutions and only
        holds a portion of the total outstanding loan.  The construction
        project experienced substantial cost overruns and the principal borrowers
        declared bankruptcy.  The construction project has been completed and
        all of the units have been sold, with the bankruptcy trustee holding the
        sale
        proceeds in escrow.  There are disputed mechanic liens of which the
        majority are insured by a title company.  The bankruptcy trustee
        during 2006 released funds held in the escrow to the Company reducing the
        loan
        balance by $2.7 million.  The bankruptcy trustee is still holding
        funds in escrow until the disputed mechanic liens are
        resolved.  Due
   17
  to
        court
        delays, the mechanic liens issue is not expected to be concluded until the
        first
        half of 2008.  Management expects to collect all of the remaining $1.5
        million loan balance from the bankruptcy trustee.
 
 The
        Company has a restructured nonaccrual loan with a carrying amount of $1.2
        million at September 30, 2007, to a heavy equipment contractor that is secured
        by real estate.  The original restructured 4-month loan agreement has
        lapsed and subsequent to September 30, 2007 payment of $200,000 was received
        reducing the outstanding balance to $1.0 million.  The Company is in
        negotiations to extend the agreement an additional 6 months to allow the
        borrower to sell the properties.  If the properties are not sold in
        that time, the Bank may take possession of several of the properties in lieu
        of
        foreclosure.  The Company believes that the value of the secured real
        estate is sufficient to collect all of the outstanding loan
        balance.
 
 At
        September 30, 2007, there are nonaccrual loans totaling $465,000 on a
        restaurant/tavern secured by real estate that the borrower is attempting
        to
        sell.  The Bank has $50,000 of the allowance for loan and lease losses
        specifically allocated to these loans.
 
 Impaired
        loans and leases at September 30, 2007 totaled $5.2 million as compared with
        $9.5 million at December 31, 2006.  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, if the loan or lease is collateral
        dependent.
 
 Another
        component of nonperforming assets is other real estate owned, consisting
        of
        assets acquired through loan foreclosure and repossession. At September 30,
        2007, other real estate owned totaled $2.9 million, decreasing from $3.0
        million
        at December 31, 2006.  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 lower of cost or the fair value less estimated
        selling costs.
 
 A
        two-story office building in Waukegan, Illinois that had been transferred
        to
        other real estate owned in 2004 has a carrying value of $1,147,000 as of
        September 30, 2007.  During the third quarter 2007, a contract to
        lease/purchase this property that had been in effect in which monthly payments
        of $7,700 were made to the Bank was allowed to lapse by the
        renter/purchaser.  The Company is making efforts to sell this
        property.
 
 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 September 30,
        2007.  Environmental remediation costs may be incurred in disposing of
        this property.  There is no requirement to undertake any remediation
        activities at this time.  Further, there is no pending or threatened
        litigation regarding the property’s environmental issues, nor are there any
        threatened or pending governmental orders, assessments or actions regarding
        the
        same.  During the quarter ending September 30, 2007, the Company
        received the preliminary results of the brownfield assessment on the
        property.  These preliminary results showed that an end use of
        construction of mid-rise residential housing on the site would allow
        encapsulation of questionable soils at the site at an estimated cost of
        approximately $485,000.  To remediate the property for the
        construction of single family dwellings at the site would require removal
        of the
        soil at an estimated cost of approximately $4.8 million.  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 Bank’s
        carrying value plus the estimated cost of encapsulation of $485,000 for the
        end
        use of mid-rise residential units.  Due to uncertainties as to the end
        use of the property, at this time no liability has been recorded for these
        estimated environmental remediation costs.
 
 18
  NONINTEREST
        INCOME
 
 Noninterest
        income for the three months ended September 30, 2007 was $1.2 million compared
        to $1.3 million for the three months ended September 30, 2006, a decrease
        of
        $81,000.  Service fees on deposits increased $111,000 due to increased
        service charges on commercial checking accounts and continued increases to
        overdraft fee income during the third quarter 2007.  Other operating
        income during the third quarter of 2007 was $305,000, a decline
        of  $191,000 from the same quarter last year.  The decrease
        in other operating income is due to mortgage banking income decreasing $29,000
        due to a decline in these activities and ATM and debit fee income decreasing
        $66,000 from last year due to changes to the recognition of this fee
        source.  Contributing to the decline was a gain on real estate owned
        of $80,000 during the third quarter 2006, while in the third quarter of 2007
        there were no such gains.
  For
        the
        nine months ended September 30, 2007, noninterest income was $3.8 million,
        an
        increase of $121,000 from the same time period last
        year.  Contributing to the increase was service fees on deposits that
        were $249,000 greater than for the same nine months last year.  Trust
        income was also $28,000 greater for the nine months ended September 30, 2007
        compared to last year.  Other operating income declined $156,000 as
        gains on sales of other real estate owned were $70,000 less during the nine
        months ended September 30, 2007 as compared to the same period last
        year.  Fee income on ATM and debit card transactions was also $102,000
        less than last year.
 
 NONINTEREST
        EXPENSE
  Noninterest
        expense for the quarter ended September 30, 2007 was $4,230,000, increasing
        only  $40,000 or 1 percent from the same quarter last
        year.  Salaries and employee expense declined during the quarter by
        $110,000 due to increased efficiencies as the Company’s restructuring of the
        balance sheet allowing the Company to reduce the number of full time equivalent
        employees to 153 at September 30, 2007 as compared to 180 at December 31,
        2006.  Offsetting the decline in salaries, legal expense increased
        $92,000 and audit and other professional fees increased
        $74,000.  Legal expense expenses increased during the quarter due to
        litigation involving the nonperforming loans, while audit and other professional
        fees increased in part due to professional fees paid to FTN for advisory
        services pertaining to the administration of the Company’s securities portfolio
        that began during the third quarter of 2007.
 
 The
        Company’s efficiency ratio, noninterest expense divided by the sum of net
        interest income and noninterest income, was 71.0 percent for the third quarter
        of 2007 as compared with 80.7 percent for the same quarter of 2006. The lower
        ratio for the three months ended September 30, 2007 reflects the increased
        net
        interest income in the third quarter of 2007 compared to the same time period
        last year.
 
 For
        the nine months ended September 30,
        2007, noninterest expense was $12.9 million, decreasing $114,000 from $13.0
        million for the same period last year.  Noninterest expense declined
        during the first nine months of 2007 as compared with the same period of
        2006
        primarily due to decreases to salaries and other employee benefits of $140,000
        and other operating expenses of $218,000.  Other operating expenses
        declined due to a reduction to other real estate owned expense of $98,000
        as the
        Bank received rent payments on a building it had foreclosed on that have
        now
        stopped.  Other operating expenses also were reduced, as FDIC expense
        was $92,000 less as the Bank’s risk rating was upgraded.  Partially
        offsetting these declines were increases to occupancy and equipment expenses
        of
        $109,000 and legal expenses of $124,000.  Occupancy and equipment
        expenses increased as maintenance expenses continue to rise due to the age
        of
        the Company’s buildings and equipment, while legal expenses increased due to
        nonperforming loan issues.
 
 FEDERAL
        AND STATE INCOME TAXES
  For
        the
        three months ended September 30, 2007, the Company’s income tax expense was
        $183,000 compared with $279,000 for the same three months last
        year.  As a percentage of pre-tax income, tax expense was 24.0% for
        the three months ended September 30, 2007 and 27.9% for the same period of
        2006.
        The decrease in tax rate for the third quarter of 2007 was caused by the
        decrease in taxable income during
   19
  the
        quarter.  As a percentage of pre-tax income, tax expense was 31.0% for
        the nine months ended September 30, 2007 and 25.6% for the same period of
        2006.  The tax rate increased for the nine months ended September 30,
        2007 due to the growth of the Company’s taxable income while nontaxable income
        items remained constant in 2007 as compared with 2006.
 
 The
        Bank
        earned interest income from U.S. Treasury and U.S. government-sponsored entity
        securities not subject to state income tax of $1.7 million during the third
        quarter of 2007 as compared with $1.9 million during the same quarter of
        2006.  For the nine months of 2007, U.S. Treasury and U.S.
        government-sponsored entity securities interest not subject to state income
        tax
        was $6.1 million as compared with $5.9 million during the same period of
        2006.  It is expected that interest on U.S. government-sponsored
        securities will decrease as the balances on these securities have decreased
        $123.5 million since the beginning of 2007. The Bank has generated state
        tax
        credits during the nine months ended September 30, 2007 of $62,000 as compared
        with credits of $172,000 during the same period of 2006.  The Company
        expects to generate sufficient taxable income for state tax return purposes
        within 12 years in order to use up these tax credits.  If the Company
        would be unable to generate sufficient state taxable income within the 12
        years
        it would need to reverse these credits.
 
 CONTRACTUAL
        OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
  The
        Company has contractual obligations that may not appear on the balance
        sheet.  Table 3 presents the Company’s significant fixed and
        determinable contractual obligations as of September 30, 2007 by payment
        date.
        The payment amounts in Table 3 represent those amounts contractually due
        to the
        recipient and do not include any unamortized premiums or discounts or similar
        carrying amount adjustments.
  TABLE
          3
  NORTHERN
            STATE FINANCIAL CORPORATION
 CONTRACTUAL
              OBLIGATIONS
 As
                of
                September 30, 2007
 ($
                  000s)
  Greater
                  than
              
              
              Greater
                  than1
                  yr. and less
              
              
              3
                  yrs. and lessOne
                  year
              
              
              than
                  or equal
              
              
              than
                  or equal
              
              
              Greater
                  thanContractual
                  obligations
              
              or
                  less
              
              
              to
                  3 yrs.
              
              
              to
                  5 yrs.
              
              
              5
                  yrs.
              
              
              TotalLong-term
                  debtSubordinated
                  debentures
              
              $
              -
              
              
              $
              -
              
              
              $
              -
              
              
              $
              10,000
              
              
              $
              10,000Time
                  deposits
              
              
              193,716
              
              
              
              54,621
              
              
              
              65
              
              
              
              -
              
              
              
              248,402Other
                  contractual obligationsStandby
                  letters of credit
              
              
              11,398
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              11,398Community
                  Reinvestment Actinvestment
                  commitment
              
              
              220
              
              
              
              51
              
              
              
              -
              
              
              
              -
              
              
              
              271
  
 **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.
   20
  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.
 
 One
        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. The Company's primary asset/liability management
        technique is the interest rate shock.
 
 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.  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 the
        lower yielding securities may remain in the Company’s securities portfolio until
        maturity.
  Table
        4
        shows how interest rate shocks of decreasing rates 1 percent and 2 percent
        and
        increasing rates 1% and 2% affect projected 12 month projected net interest
        income at September 30, 2007 and December 31, 2006.  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
        September 30, 2007 the projected net interest income increases $368,000 when
        rates are shocked upward 2 percent while projected net interest income decreases
        $605,000 for a 2 percent downward rate shock.   At December 31,
        2006 projected net interest income decreased $800,000 when rates were shocked
        upward 2 percent while projected net interest income decreased only slightly,
        by
        $10,000, for a 2 percent downward rate shock.  The reason for this
        change is that for the September 30, 2007 rate shock analysis the Company
        refined the assumptions used in the model regarding its money market accounts
        and the extent that interest rates on money market would change during a
        rate
        shock.
 
 A
        review
        of the extent that interest rate changes affected money market interest rates
        at
        the Company during the past 10 years showed that when rates went up 100 basis
        points that the money market rates would increase only 45 basis
        points.  Historically, when rates went down 100 basis points, the
        Company only dropped money market rates by 45 basis points as
        well.  These assumptions were used for the September 30, 2007 computer
        simulation.  At December 31, 2006 the assumption used for money market
        interest rates was that for each 100 basis point rate change either up or
        down
        that the money market rate would correspondingly go up and down 100 basis
        points.   The effect of using the refined assumptions based on
        historical correlations at September 30, 2007 shows net interest income
        increasing with upward rate shocks and net interest income declining with
        downward rate shocks.
 
 21
  At
        both
        September 30, 2007 and December 31, 2006, the percentage changes from the
        base
        forecasted 12-month net interest income are within policy
        guidelines.
  TABLE
          4
  NORTHERN
            STATES FINANCIAL CORPORATION
 EFFECT
              OF
              INTEREST SHOCKS ON NET INTEREST INCOME
 as
            of
            September 30, 2007 and December 31, 2006
 ($000s)
  Immediate
                  Change in Rates-2.00
              %
              
              
              -1.00
              %
              
              
              +1.00
              %
              
              
              +2.00
              %September
                  30, 2007:Dollar
                  Change from Base Forecast
              
              $
              (605
              )
              
              $
              (221
              )
              
              $
              485
              
              
              $
              368Percent
                  Change from Base Forecast
              
              
              -3.14
              %
              
              
              -1.15
              %
              
              
              2.51
              %
              
              
              1.91
              %December
                  31, 2006:Dollar
                  Change from Base Forecast
              
              $
              (10
              )
              
              $
              (2
              )
              
              $
              (326
              )
              
              $
              (800
              )Percent
                  Change from Base Forecast
              
              
              -0.06
              %
              
              
              -0.01
              %
              
              
              -1.94
              %
              
              
              -4.77
              %
 
 
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **ITEM
        4. CONTROLS AND
        PROCEDURES**
 
 The
        Company maintains disclosure controls and procedures that are designed to
        ensure
        that information required to be disclosed in the reports that the Company
        files
        or submits under the Securities Exchange Act of 1934 is recorded, processed,
        summarized, and reported within the time periods specified in the SEC's rules
        and regulations, and that such information is accumulated and communicated
        to
        the Company's management, including its Chairman of the Board and President
        and
        Vice President and Treasurer, as appropriate, to allow timely decisions
        regarding required disclosures.
 
 As
        of the
        end of the period covered by this Quarterly Report on Form 10-Q, the Company
        carried out an evaluation, under the supervision and with the participation
        of
        the Company's management, including the Chairman of the Board and President
        and
        Vice President and Treasurer, of the effectiveness of the design and operation
        of the Company’s disclosure controls and procedures pursuant to Securities
        Exchange Act Rule 13a-15(e) and 15d-15(e). Based upon this evaluation as
        of June
        30, 2007, the Chairman of the Board and President and Vice President and
        Treasurer concluded that our disclosure controls and procedures were not
        effective for the reasons more fully described below related to the weakness
        in
        our internal control over financial reporting identified during the audit
        of the
        2006 internal control over financial reporting evaluation in connection with
        Section 404 of the Sarbanes-Oxley Act of 2002.  Progress continues to
        be made to remediate this material weakness that was identified at December
        31,
        2006.  To address the control weakness, the Company performed updated
        procedures to ensure the unaudited quarterly consolidated financial statements
        are prepared in accordance with generally accepted accounting
        principles.  Accordingly, management believes that the consolidated
        financial statements included in this Quarterly Report on Form 10-Q, fairly
        present, in all material respects, our consolidated financial condition,
        consolidated results of operations and cash flows for the periods
        presented.
 
 22
  **NORTHERN
        STATES FINANCIAL CORPORATION**
 
 
 Management’s
        assessment continued to identify the following material weakness in the
        Company’s internal control over financial reporting as of September 30, 2007
        (this section of Item 4. “Controls and Procedures” should be read in conjunction
        with Item 9A. “Controls and Procedures,” included in the Company's Form 10-K for
        the year ended December 31, 2006, for additional information on Management's
        Assessment of Internal Control Over Financial Reporting):
  1.  Deficiencies
        in the general controls over the reconciliation of the ATM clearing account
        resulted in improper recognition of ATM fee income due to a procedural
        bookkeeping error. The system of monitoring the ATM procedures was not effective
        in preventing the improper recognition of noninterest
        income.  Accordingly, management concluded that this matter represents
        a material weakness of control over financial reporting.
  The
        Company identified this deficiency in its internal control over financial
        reporting during the audit of the year ended December 31, 2006 and accordingly,
        this control deficiency is in the process of being remediated. The finding
        discussed above was characterized as a material weakness in accordance with
        the
        rules and regulations of the Securities and Exchange Commission, as a more
        than
        remote possibility that a material misstatement to the Company's interim
        or
        annual financial statements could occur.  However, the internal
        control weakness identified by management did not cause a material misstatement
        or have an adverse impact to the Company's financial position, results of
        operations or control environment as of and for the three and nine months
        ended
        September 30, 2007.
 
 **Changes
        in Internal Control over Financial Reporting**
 
 To
        address and remediate the material weaknesses in the Company's internal control
        over financial reporting at December 31, 2006, the Company made changes to
        its
        internal controls during the most recently completed fiscal quarter ended
        September 30, 2007 that has materially affected, or is reasonable likely
        to
        materially affect, the Company's internal controls over financial
        reporting.  Management, with the oversight of the Audit Committee, has
        addressed the issue and has taken steps to remediate the weakness. These
        remediation measures include changes to accounting procedures for the booking
        of
        ATM fee income as well as training of those persons monitoring and balancing
        the
        ATM procedures to insure that these errors do not reoccur.
 
 The
        Company believes that the measures above have addressed the matter identified
        as
        a material weakness by management, however, the formal assessment and testing
        procedures have not been completed by management or the Company’s independent
        auditors as of September 30, 2007, and as such, the material weakness continues
        to exist.  The Company will continue to monitor the effectiveness of
        its disclosure controls and procedures, including its internal controls and
        procedures, on an ongoing basis and will take further actions, as
        appropriate.
 
 **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.  Other than as described
        below, 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.
 
 23
  **NORTHERN
        STATES FINANCIAL CORPORATION**
  Between
        November 2000 and
        August 2001, the Company purchased commercial lease pools from Commercial
        Money Center, a now bankrupt equipment leasing company.  The lease
        pools have outstanding balances of $4.0 million at September 30, 2007, but
        have
        been written down to a carrying value of $2.0 million. These lease pools
        are
        secured by assignments of rental payment streams and surety bonds.  A
        large part of our underwriting decision on these leases was based on the
        guarantees of the sureties.  These lease pools were included as
        impaired loans and leases at September 30, 2007 as they were at December
        31,
        2006, 2005 and 2004. Upon default of these lease pools, the Company made
        demand
        for payment from RLI Insurance Company (“RLI”) under the relevant surety
        bonds.  RLI (the “Surety”) has failed to make the payments required
        under the surety bonds.  As a result, in April 2002, the Company
        filed suit against the Surety.  The Company’s complaints alleged that
        the Surety is liable for payment due to the Company under the terms of the
        bonds.  RLI is seeking to rescind on the surety bonds alleging that
        the originator of the leases fraudulently induced the insurers to issue the
        surety bonds, and that the bonds are therefore void.  The Company has
        reviewed these matters with its legal counsel and believes that it has valid
        claims as the Surety undertook the responsibility for all credit and fraud
        underwriting, and waived all defenses associated with the bonds, including
        defenses of fraud. The Company will continue to assert all the rights and
        remedies available to it to obtain payment under the bonds.  However,
        there can be no assurance as to the exact amounts that the Company will
        ultimately succeed in collecting, if any.
 
 
 **ITEM1A.  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, 2006, in response to Item 1A. to Part I of Form 10-K.
 
 
 **ITEM
        2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE
        OF PROCEEDS**
 
 
 **Issuer
        Purchases of Equity Securities**
  There
        were no purchases made by, or on behalf of, the Company of shares of the
        Company’s common stock during the quarterly period ended September 30,
        2007.
 
 
 **ITEM3.  DEFAULTS
        UPON SENIOR
        SECURITIES**
  None
 
  **ITEM
        4.  SUBMISSION OF MATTERS TO A VOTE OF
        SECURITY HOLDERS**
 
 None
 
 
 **ITEM5.  OTHER
        INFORMATION**
  None
   24
  **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.
   25
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 **FORM
        10-Q**
 **For
        the Quarter ended September 30, 2007**
 
 
 
 
 
 **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 7th day of November
        2007.
 
 
 
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 (Registrant)
 
  Date: 
                        November 7, 2007
                      By:
                      /s/Fred
                        AbdulaFred
                          Abdula
                        Chairman
                          of the Board of
                        Directors
                          and President
 Date: 
                              November 7, 2007
                            By:
                            /s/Thomas
                              M. NemethThomas
                                M. Nemeth
                              Vice
                                President and Treasurer
 26
  **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.
 
 27