United
States


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.   20549


________________________________________________________





FORM
10-Q





ý     QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d)


OF
THE SECURITIES EXCHANGE ACT OF 1934


For the
quarterly period ended September 30, 2008


OR


 ̈      TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d)


OF
THE SECURITIES EXCHANGE ACT OF 1934





For the
transition period from _________  to __________


_________________________________________________________





NORTHERN
STATES FINANCIAL CORPORATION


(Exact
name of Registrant as specified in its charter)


Delaware
                0-19300
                36-3449727(State
      of Incorporation)
                (Commission
                (I.R.S.
      EmployerFile
      Number)
                Identification
      No.)
 1601
North Lewis Avenue
 Waukegan,
Illinois  60085
 (847)
244-6000
 (Address,
including zip code, and telephone number, including


area
code, of principal executive office)


_________________________________________________________





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





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See definitions of “large accelerated filer”, “accelerated
filer” and “smaller reporting company” in Rule 12b-2 of the Exchange
Act.  (Check one):


Large
Accelerated Filer  ̈    Accelerated
Filer ý    Non-accelerated
Filer  ̈    Smaller
reporting company  ̈





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).   YES:   ̈         NO:  ý





4,072,255
shares of common stock were outstanding


at
November 3, 2008















NORTHERN
STATES FINANCIAL CORPORATION AND SUBSIDIARY


FORM
10-Q


For the Quarter Ended
September 30, 2008


INDEX




Page
      NumberPART
      I.
                                                FINANCIAL
      INFORMATIONItem
      1.
                                                Financial
      StatementsReport of  Independent Registered Public
      Accounting Firm
                                                
                                                
                                                2Condensed Consolidated Financial Statements and
      Notes
                                                
                                                
                                                3Item 2.
                                                Management’s Discussion and Analysis of
      Financial Condition and Results of Operations
                                                
                                                
                                                10Item 3.
                                                Quantitative and Qualitative Disclosures About
      Market Risk
                                                
                                                
                                                25Item 4.
                                                Controls and Procedures
                                                
                                                
                                                27PART
      II.
                                                OTHER
      INFORMATIONItem 1.
                                                Legal Proceedings
                                                
                                                
                                                27Item 1A.
                                                Risk Factors
                                                
                                                
                                                27Item 2.
                                                Unregistered Sales of Equity Securities and Use
      of Proceeds
                                                
                                                
                                                27Item 3.
                                                Defaults upon Senior Securities
                                                
                                                
                                                27Item 4.
                                                Submission of Matters to a Vote of Security
      Holders
                                                
                                                
                                                27Item 5.
                                                Other Information
                                                
                                                
                                                28Item 6.
                                                Exhibits
                                                
                                                
                                                28Signatures
                                                
                                                
                                                29EXHIBIT INDEX
                                                
                                                
                                                30




1
 Index





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, 2008, the condensed
consolidated statements of income for the three and nine month periods ended
September 30, 2008 and 2007 and the condensed statements of cash flows and
stockholders equity for the nine month periods ended September 30, 2008 and
2007.  These interim financial statements are the responsibility of
the company's management.





We
conducted our review in accordance with standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with the
standards of the Public Company Accounting Oversight Board, the objective of
which is the expression of an opinion regarding the financial statements taken
as a whole. Accordingly, we do not express such an opinion.





Based on
our review, we are not aware of any material modifications that should be made
to the accompanying interim condensed financial statements for them to be in
conformity with accounting principles generally accepted in the United States of
America.











/s/ Plante &
Moran, PLLC





Chicago,
Illinois


November
4, 2008








2
 Index




NORTHERN STATES FINANCIAL
      CORPORATIONCONDENSED CONSOLIDATED BALANCE
      SHEETSSeptember
      30, 2008 and December 31, 2007(In
      thousands of dollars) (Unaudited)September
      30,
                    
                    
                    December
      31,Assets
                    
                    2008
                    
                    
                    2007Cash
      and due from banks
                    
                    $
                    13,898
                    
                    
                    $
                    14,273Interest
      bearing deposits in financial institutions -maturities
      less than 90 days
                    
                    
                    196
                    
                    
                    
                    180Federal
      funds sold
                    
                    
                    42,938
                    
                    
                    
                    9,181Total
      cash and cash equivalents
                    
                    
                    57,032
                    
                    
                    
                    23,634Securities
      available for sale
                    
                    
                    121,822
                    
                    
                    
                    153,277Loans
      and leases
                    
                    
                    489,815
                    
                    
                    
                    435,734Less:
      Allowance for loan and lease losses
                    
                    
                    (9,932
                    )
                    
                    
                    (4,606
                    )Loans
      and leases, net
                    
                    
                    479,883
                    
                    
                    
                    431,128Federal
      Home Loan Bank stock
                    
                    
                    1,757
                    
                    
                    
                    1,445Office
      buildings and equipment, net
                    
                    
                    9,648
                    
                    
                    
                    9,198Other
      real estate owned
                    
                    
                    4,636
                    
                    
                    
                    2,857Goodwill
                    
                    
                    9,522
                    
                    
                    
                    9,522Core
      deposit intangible asset
                    
                    
                    1,042
                    
                    
                    
                    1,390Accrued
      interest receivable and other assets
                    
                    
                    9,366
                    
                    
                    
                    5,705Total
      assets
                    
                    $
                    694,708
                    
                    
                    $
                    638,156Liabilities
      and Stockholders' EquityLiabilitiesDepositsDemand
      - noninterest bearing
                    
                    $
                    55,974
                    
                    
                    $
                    60,015Interest
      bearing
                    
                    
                    437,147
                    
                    
                    
                    420,944Total
      deposits
                    
                    
                    493,121
                    
                    
                    
                    480,959Securities
      sold under repurchase agreements
                    
                    
                    52,019
                    
                    
                    
                    66,797Federal
      Home Loan Bank advances
                    
                    
                    35,000
                    
                    
                    
                    0Federal
      funds purchased
                    
                    
                    30,000
                    
                    
                    
                    0Subordinated
      debentures
                    
                    
                    10,000
                    
                    
                    
                    10,000Advances
      from borrowers for taxes and insurance
                    
                    
                    557
                    
                    
                    
                    1,066Accrued
      interest payable and other liabilities
                    
                    
                    5,988
                    
                    
                    
                    5,880Total
      liabilities
                    
                    
                    626,685
                    
                    
                    
                    564,702Stockholders'
      EquityCommon
      stock (Par value $.40 per share, 6,500,000 authorized,4,472,255
      shares issued at September 30, 2008 and December 31, 2007)
                    
                    
                    1,789
                    
                    
                    
                    1,789Additional
      paid-in capital
                    
                    
                    11,584
                    
                    
                    
                    11,584Retained
      earnings
                    
                    
                    63,625
                    
                    
                    
                    66,983Treasury
      stock, at cost (400,000 shares at September 30, 2008and
      294,150 at December 31, 2007)
                    
                    
                    (9,280
                    )
                    
                    
                    (7,202
                    )Accumulated
      other comprehensive income
                    
                    
                    305
                    
                    
                    
                    300Total
      stockholders' equity
                    
                    
                    68,023
                    
                    
                    
                    73,454Total
      liabilities and stockholders' equity
                    
                    $
                    694,708
                    
                    
                    $
                    638,156


The
accompanying notes are an integral part of these condensed consolidated
financial statements.


3
 Index




NORTHERN STATES FINANCIAL
      CORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF
      INCOMEThree
      and nine months ended September 30, 2008 and 2007(In
      thousands of dollars, except per share data) (Unaudited)Three
      months ended
                    
                    
                    Nine
      months endedSeptember
      30,
                    
                    
                    September
      30,
                    
                    
                    September
      30,
                    
                    
                    September
      30,2008
                    
                    
                    2007
                    
                    
                    2008
                    
                    
                    2007Interest
      incomeLoans
      (including fee income)
                    
                    $
                    7,287
                    
                    
                    $
                    7,059
                    
                    
                    $
                    21,585
                    
                    
                    $
                    20,455SecuritiesTaxable
                    
                    
                    1,544
                    
                    
                    
                    2,283
                    
                    
                    
                    5,137
                    
                    
                    
                    7,262Exempt
      from federal income tax
                    
                    
                    121
                    
                    
                    
                    72
                    
                    
                    
                    347
                    
                    
                    
                    214Commercial
      paper - maturities less than 90 days
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0Federal
      funds sold and other
                    
                    
                    8
                    
                    
                    
                    271
                    
                    
                    
                    91
                    
                    
                    
                    751Total
      interest income
                    
                    
                    8,960
                    
                    
                    
                    9,685
                    
                    
                    
                    27,160
                    
                    
                    
                    28,682Interest
      expenseTime
      deposits
                    
                    
                    2,263
                    
                    
                    
                    3,017
                    
                    
                    
                    7,541
                    
                    
                    
                    9,205Other
      deposits
                    
                    
                    396
                    
                    
                    
                    920
                    
                    
                    
                    1,288
                    
                    
                    
                    2,841Repurchase
      agreements and federal funds purchased
                    
                    
                    279
                    
                    
                    
                    809
                    
                    
                    
                    922
                    
                    
                    
                    2,720Federal
      Home Loan Bank advances
                    
                    
                    137
                    
                    
                    
                    28
                    
                    
                    
                    289
                    
                    
                    
                    205Subordinated
      debentures
                    
                    
                    137
                    
                    
                    
                    170
                    
                    
                    
                    433
                    
                    
                    
                    506Total
      interest expense
                    
                    
                    3,212
                    
                    
                    
                    4,944
                    
                    
                    
                    10,473
                    
                    
                    
                    15,477Net
      interest income
                    
                    
                    5,748
                    
                    
                    
                    4,741
                    
                    
                    
                    16,687
                    
                    
                    
                    13,205Provision
      for loan and lease losses
                    
                    
                    5,146
                    
                    
                    
                    967
                    
                    
                    
                    8,129
                    
                    
                    
                    (458
                    )Net
      interest income after provision forloan
      and lease losses
                    
                    
                    602
                    
                    
                    
                    3,774
                    
                    
                    
                    8,558
                    
                    
                    
                    13,663Noninterest
      incomeService
      fees on deposits
                    
                    
                    672
                    
                    
                    
                    731
                    
                    
                    
                    1,953
                    
                    
                    
                    2,093Gains
      on sales of securities
                    
                    
                    40
                    
                    
                    
                    0
                    
                    
                    
                    40
                    
                    
                    
                    0Impairment
      losses on securities
                    
                    
                    (2,180
                    )
                    
                    
                    0
                    
                    
                    
                    (2,180
                    )
                    
                    
                    0Trust
      income
                    
                    
                    188
                    
                    
                    
                    184
                    
                    
                    
                    619
                    
                    
                    
                    611Other
      operating income
                    
                    
                    279
                    
                    
                    
                    305
                    
                    
                    
                    823
                    
                    
                    
                    1,092Total
      noninterest income
                    
                    
                    (1,001
                    )
                    
                    
                    1,220
                    
                    
                    
                    1,255
                    
                    
                    
                    3,796Noninterest
      expenseSalaries
      and employee benefits
                    
                    
                    2,127
                    
                    
                    
                    2,097
                    
                    
                    
                    6,432
                    
                    
                    
                    6,546Occupancy
      and equipment, net
                    
                    
                    580
                    
                    
                    
                    548
                    
                    
                    
                    1,801
                    
                    
                    
                    1,791Data
      processing
                    
                    
                    415
                    
                    
                    
                    389
                    
                    
                    
                    1,278
                    
                    
                    
                    1,216Legal
                    
                    
                    144
                    
                    
                    
                    149
                    
                    
                    
                    304
                    
                    
                    
                    371Audit
      and other professional
                    
                    
                    260
                    
                    
                    
                    333
                    
                    
                    
                    997
                    
                    
                    
                    917Amortization
      of core deposit intangible asset
                    
                    
                    116
                    
                    
                    
                    117
                    
                    
                    
                    348
                    
                    
                    
                    348Printing
      and supplies
                    
                    
                    79
                    
                    
                    
                    90
                    
                    
                    
                    230
                    
                    
                    
                    303Other
      operating expenses
                    
                    
                    508
                    
                    
                    
                    507
                    
                    
                    
                    1,588
                    
                    
                    
                    1,394Total
      noninterest expense
                    
                    
                    4,229
                    
                    
                    
                    4,230
                    
                    
                    
                    12,978
                    
                    
                    
                    12,886Income
      before income taxes
                    
                    
                    (4,628
                    )
                    
                    
                    764
                    
                    
                    
                    (3,165
                    )
                    
                    
                    4,573Income
      tax expense (benefit)
                    
                    
                    (1,847
                    )
                    
                    
                    183
                    
                    
                    
                    (1,435
                    )
                    
                    
                    1,416Net
      income
                    
                    $
                    (2,781
                    )
                    
                    $
                    581
                    
                    
                    $
                    (1,730
                    )
                    
                    $
                    3,157Earnings
      per share
                    
                    $
                    (0.68
                    )
                    
                    $
                    0.14
                    
                    
                    $
                    (0.42
                    )
                    
                    $
                    0.75Comprehensive
      income
                    
                    $
                    1,457
                    
                    
                    $
                    1,483
                    
                    
                    $
                    415
                    
                    
                    $
                    4,656


The
accompanying notes are an integral part of these condensed consolidated
financial statements.


4
 Index




NORTHERN STATES FINANCIAL
      CORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF CASH
      FLOWSNine
      months ended September 30, 2008 and 2007(In
      thousands of dollars) (Unaudited)Nine
      months endedSeptember
      30,
                        
                        
                        September
      30,2008
                        
                        
                        2007Cash
      flows from operating activitiesNet
      income (loss)
                        
                        $
                        (1,730
                        )
                        
                        $
                        3,157Adjustments
      to reconcile net income to net cash fromoperating
      activities:Depreciation
                        
                        
                        391
                        
                        
                        
                        435Net
      gains on sales of securities
                        
                        
                        (40
                        )
                        
                        
                        0Impairment
      losses on securities
                        
                        
                        2,180
                        
                        
                        
                        0Provision
      for loan and lease losses
                        
                        
                        8,129
                        
                        
                        
                        (458
                        )(Gain)
      Loss on sale of other real estate owned
                        
                        
                        0
                        
                        
                        
                        8Deferred
      loan fees
                        
                        
                        330
                        
                        
                        
                        28Amortization
      of other intangible assets
                        
                        
                        348
                        
                        
                        
                        347Net
      change in accrued interest receivable and other assets
                        
                        
                        (3,720
                        )
                        
                        
                        965Net
      change in accrued interest payable and other liabilities
                        
                        
                        108
                        
                        
                        
                        (163
                        )Net
      cash from operating activities
                        
                        
                        5,996
                        
                        
                        
                        4,319Cash
      flows from investing activitiesProceeds
      from maturities and calls of securities available for sale
                        
                        
                        83,362
                        
                        
                        
                        167,078Proceeds
      from sales of securities available for sale
                        
                        
                        8,240
                        
                        
                        
                        0Purchases
      of securities available for sale
                        
                        
                        (62,223
                        )
                        
                        
                        (90,227
                        )Purchases
      of Federal Home Loan Bank stock
                        
                        
                        (312
                        )
                        
                        
                        0Change
      in loans made to customers
                        
                        
                        (58,780
                        )
                        
                        
                        (35,729
                        )Proceeds
      from sales of other real estate owned
                        
                        
                        0
                        
                        
                        
                        118Improvements
      to other real estate owned
                        
                        
                        (213
                        )Property
      and equipment expenditures
                        
                        
                        (841
                        )
                        
                        
                        (316
                        )Net
      cash from investing activities
                        
                        
                        (30,767
                        )
                        
                        
                        40,924Cash
      flows from financing activitiesNet
      increase (decrease) in:Deposits
                        
                        
                        12,162
                        
                        
                        
                        (31,441
                        )Securities
      sold under repurchase agreementsand
      federal funds purchased
                        
                        
                        15,222
                        
                        
                        
                        (11,822
                        )Advances
      from borrowers for taxes and insurance
                        
                        
                        (509
                        )
                        
                        
                        (219
                        )Federal
      Home Loan Bank advances
                        
                        
                        70,000
                        
                        
                        
                        10,000Repayment
      of Federal Home Loan Bank advances
                        
                        
                        (35,000
                        )
                        
                        
                        (21,500
                        )Purchase
      of treasury stock
                        
                        
                        (2,078
                        )
                        
                        
                        (1,241
                        )Dividends
      paid
                        
                        
                        (1,628
                        )
                        
                        
                        (1,462
                        )Net
      cash used in financing activities
                        
                        
                        58,169
                        
                        
                        
                        (57,685
                        )Net
      change in cash and cash equivalents
                        
                        
                        33,398
                        
                        
                        
                        (12,442
                        )Cash
      and cash equivalents at beginning of period
                        
                        
                        23,634
                        
                        
                        
                        29,986Cash
      and cash equivalents at end of period
                        
                        $
                        57,032
                        
                        
                        $
                        17,544The
      accompanying notes are an integral part of these condensed consolidated
      financial statements.





5
 Index




NORTHERN
STATES FINANCIAL CORPORATION
 CONDENSED CONSOLIDATED
STATEMENTS OF STOCKHOLDERS'EQUITY
 Nine
months ended Sepember 30, 2008 and 2007
 (In
thousands of dollars, except for per share data) (Unaudited)





Common
                                  Stock
                                
                                
                                Additional
                                  Paid-In
                                  Capital
                                
                                
                                Retained
                                  Earnings
                                
                                
                                Treasury
                                  Stock,
      at Cost
                                
                                
                                Accumulated
                                  Other
                                  Comprehensive
                                  Income
      (Loss)
                                
                                
                                Total
                                  Stockholders'
                                  EquityBalance,
      December 31, 2006
                                
                                $
                                1,789
                                
                                
                                $
                                11,584
                                
                                
                                $
                                65,603
                                
                                
                                $
                                (5,961
                                )
                                
                                $
                                (1,552
                                )
                                
                                $
                                71,463Net
      income
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                3,157
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                3,157Cash
      dividends ($0.35 per share)
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                (1,462
                                )
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                (1,462
                                )Purchase
      of 55,000 shares of treasury stock
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                (1,241
                                )
                                
                                
                                
                                
                                
                                
                                (1,241
                                )Unrealized
      gain on securities available for sale, net of deferred
      tax
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                1,499
                                
                                
                                
                                1,499Balance,
      September 30, 2007
                                
                                $
                                1,789
                                
                                
                                $
                                11,584
                                
                                
                                $
                                67,298
                                
                                
                                $
                                (7,202
                                )
                                
                                $
                                (53
                                )
                                
                                $
                                73,416Balance,
      December 31, 2007
                                
                                $
                                1,789
                                
                                
                                $
                                11,584
                                
                                
                                $
                                66,983
                                
                                
                                $
                                (7,202
                                )
                                
                                $
                                300
                                
                                
                                $
                                73,454Net
      income
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                (1,730
                                )
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                (1,730
                                )Cash
      dividends ($0.40 per share)
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                (1,628
                                )
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                (1,628
                                )Purchase
      of 105,850 shares of treasury stock
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                (2,078
                                )
                                
                                
                                
                                
                                
                                
                                (2,078
                                )Unrealized
      gain on securities available for sale, net of deferred tax and
      reclassification adjustments
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                5
                                
                                
                                
                                5Balance,
      September 30, 2008
                                
                                $
                                1,789
                                
                                
                                $
                                11,584
                                
                                
                                $
                                63,625
                                
                                
                                $
                                (9,280
                                )
                                
                                $
                                305
                                
                                
                                $
                                68,023






The
accompanying notes are an integral part of these condensed consolidated
financial statements.






6
 Index




NORTHERN STATES FINANCIAL
CORPORATION
  NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
  September
30, 2008
  (Unaudited)
  Note 1 - Basis of
Presentation
 
 The
accompanying interim condensed consolidated financial statements are prepared
without audit and reflect all adjustments which are of a normal and recurring
nature and, in the opinion of management, are necessary to present interim
financial statements of Northern States Financial Corporation (the "Company") in
accordance with accounting principles generally accepted in the United States of
America. The interim financial statements do not purport to contain all the
necessary financial disclosures covered by accounting principles generally
accepted in the United States of America that might otherwise be necessary for
complete financial statements.
  To
prepare financial statements in conformity with accounting principles generally
accepted in the United States of America, management makes estimates and
assumptions based on available information.  These estimates and
assumptions affect the amounts reported in the financial statements and the
disclosures provided, and future results could differ.  The allowance
for loan and lease losses, valuation of other real estate owned, valuation of
other than temporarily impaired securities and status of contingencies are
particularly subject to change.
  The
interim condensed financial statements should be read in conjunction with the
audited financial statements and accompanying notes (or "notes thereto") of the
Company for the years ended December 31, 2007 and 2006.  The results
of operations for the three and nine month periods ended September 30, 2008, are
not necessarily indicative of the results to be expected for the full
year.
  Net
income was utilized to calculate earnings per share for all periods
presented.   The Company had no common stock equivalents during
the first nine months of 2008 and the entire year of 2007.  The
average outstanding common shares used for earnings per share
follows:
  Three
      months ended
                
                
                Nine
      months endedSeptember
      30, 2008
                
                
                September
      30, 2007
                
                
                September
      30, 2008
                
                
                September
      30, 2007Average
      outstanding common shares
                
                
                4,072,255
                
                
                
                4,178,105
                
                
                
                4,112,356
                
                
                
                4,193,013
 
 On April
17, 2002, the Company announced that its Board of Directors had approved a stock
repurchase program that allows the Company to purchase up to 200,000 shares of
Northern States Financial Corporation stock either in open market or private
transactions.   On February 19, 2003, the Company announced that
its Board of Directors had approved an additional repurchase program to purchase
200,000 additional shares of its stock.  During the nine months ended
September 30, 2008, 105,850 shares of stock were repurchased for $2,078,000
bringing the total of Treasury stock shares to 400,000 and completing the stock
repurchase programs with no shares remaining to be repurchased.  At
September 30, 2008, the Treasury stock is carried at cost.
   7
 Index
  NORTHERN STATES FINANCIAL
CORPORATION
  NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
  September
30, 2008
  (Unaudited)
 Information
related to common stock was as follows:
  September
      30, 2008
                
                
                December
      31, 2007Par
      value per share
                
                $
                0.40
                
                
                $
                0.40Authorized
      shares
                
                
                6,500,000
                
                
                
                6,500,000Issued
      shares
                
                
                4,472,255
                
                
                
                4,472,255Treasury
      shares
                
                
                400,000
                
                
                
                294,150Outstanding
      shares
                
                
                4,072,255
                
                
                
                4,178,105
 
 Note 2 –
Impairment of Securities
 
 During
the quarter ended September 30, 2008, the Company determined that its equity
securities in Federal National Mortgage Association (FNMA) and Federal Home Loan
Mortgage Corporation (FHLMC) preferred stock were other than temporarily
impaired as the U.S. Treasury took over FNMA and FHLMC, suspended dividend
payments and began to restructure these entities.  The Company took a
write-down of $1,905,000 based on the market value of these equity securities at
September 30, 2008.
  The
Company also took a write-down of $275,000 to its other bond securities, as it
was determined that a portion of collateralized debt obligations classified as
other bonds was other than temporarily impaired.  The write-down was
based on the Financial Accounting Standards Board Staff Position No. 157-3 (“FSP
157-3”) that allows expected cash flow analysis to be used in an illiquid market
where relevant market data is unavailable, as was the case with the Company’s
collateralized debt obligations.   Reasonable judgement was used
that carefully analyzed the defaults and deferral of payments by the financial
institutions and insurance companies that had issued the debt underlying the
securities.
  Note 3 –
Subordinated Debentures
  During
September 2005, the Company issued $10 million of trust preferred securities
through Northern States Statutory Trust I, a wholly-owned grantor
trust.  The Company issued $10 million of subordinated debentures to
Northern States Statutory Trust I, which in turn issued $10 million of trust
preferred securities.  The subordinated debentures mature in September
2035.  From December 2005 until September 15, 2010, the subordinated
debentures bear interest at a rate equal to the sum of the product of 50% times
the 3-month LIBOR plus 1.80%, plus the product of 50% times 6.186%, and
thereafter at a rate equal to the 3-month LIBOR plus 1.80%.  The rate
on the subordinated debentures was 5.40238% at September 30, 2008 and is the
effective rate from September 15, 2008 through December 14, 2008.  For
the three and nine months ended September 30, 2008, interest expense on the
subordinated debentures was $137,000 and $433,000.  For the three and
nine months ended September 30, 2007, interest expense on the subordinated
debentures was $170,000 and $506,000.
   8
 Index
  NORTHERN STATES FINANCIAL
CORPORATION
  NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
  September
30, 2008
  (Unaudited)
  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.
   9
 Index




NORTHERN STATES FINANCIAL
CORPORATION
  
 ITEM 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
  The
following discussion focuses on the consolidated financial condition of Northern
States Financial Corporation (the “Company”) at September 30, 2008 and the
consolidated results of operations for the three and nine month periods ended
September 30, 2008, compared with the same periods of 2007.  The
purpose of this discussion is to provide a better understanding of the condensed
consolidated financial statements of Northern States Financial Corporation and
the operations of its wholly owned subsidiary, NorStates Bank (the “Bank”) and
the Bank’s wholly owned subsidiary, Northern States Community Development
Corporation (“NSCDC”). This discussion should be read in conjunction with the
interim condensed consolidated unaudited financial statements and notes thereto
included herein.
  Statements
contained in this report that are not historical facts may constitute
forward-looking statements (within the meaning of Section 21E of the Securities
Exchange Act of 1934, as amended), which involve significant risks and
uncertainties.  The Company intends such forward-looking statements to
be covered by the safe harbor provisions for forward-looking statements
contained in the Private Securities Litigation Reform Act of 1995, and is
including this statement for purposes of invoking these safe harbor
provisions.  Forward-looking statements, which are based on certain
assumptions and describe future plans, strategies and expectations of the
Company, are generally identifiable by the use of the words "believe," "expect,"
"intend," "anticipate," "estimate," "project," "plan," or similar
expressions.  The Company's ability to predict results or the actual
effect of future plans or strategies is inherently uncertain and actual results
may differ from those predicted.  The Company undertakes no obligation
to update these forward-looking statements in the future.  The Company
cautions readers of this report that a number of important factors could cause
the Company’s actual results subsequent to September 30, 2008 to differ
materially from those expressed in forward-looking
statements.  Factors that could cause actual results to differ from
those predicted and could have a material adverse effect on the operations of
the Company and its subsidiaries include, but are not limited to, the potential
for further deterioration in the credit quality of the Company’s loan and lease
portfolios, a continued increase in nonperforming assets, uncertainty regarding
the Company’s ability to ultimately recover on loans currently on nonaccrual
status, unanticipated changes in interest rates, general economic conditions,
increasing regulatory compliance burdens or potential legislative/regulatory
changes, monetary and fiscal policies of the U.S. Government, including policies
of the U.S. Treasury and the Federal Reserve Board, the quality or composition
of the Company’s loan or investment portfolios, deposit flows, competition,
demand for loan products and financial services in the Company’s market area,
and changes in accounting principles, policies and guidelines.  These
risks and uncertainties should be considered in evaluating forward-looking
statements.
  OVERVIEW
  Total
assets at September 30, 2008 were $694.7 million, increasing by $56.5 million or
8.9 percent, from total assets of $638.2 million at December 31,
2007.  Loans totaled $489.8 million at September 30, 2008, the highest
quarter-end level in the Company’s history, increasing $54.1 million, or 12.4
percent, from loans of $435.7 million at December 31, 2007.  The
increase in loans was primarily due to meeting the borrowing needs of the
Company’s customers.  Deposits at September 30, 2008 increased $12.2
million, or 2.5 percent, compared to December 31, 2007 as the Company increased
its brokered time deposits by $34.3 million to $78.1 million at September 30,
2008 while most other types of deposits declined as the Company, in order to
increase its net interest income, lowered deposit rates.  Securities
sold under repurchase agreements at September 30, 2008 declined $14.8 million
from December 31, 2007.  The Company increased its borrowings of
federal funds purchased and Federal Home Loan Bank term advances by $30.0
million and $35.0 million, respectively.
   10
 Index
  NORTHERN STATES FINANCIAL
CORPORATION
 The
Company reported a loss for the three months ended September 30, 2008
of  $2,781,000, or $.68 per share, compared with earnings of $581,000,
or $.14 per share, for the same period of 2007.  The loss resulted
from a $5.1 million provision for loan losses and a $2.2 million write-down of
its other than temporarily impaired securities during the
quarter.  During the third quarter of 2007, the Company had a $967,000
provision for loan losses and had no write-downs to its securities.
  The 2008
third quarter provision for loan losses of $5.1 million was attributable to
worsening economic conditions in the real estate market that have increased the
volume of the Company’s nonperforming loans by $15.8 million or 132 percent from
year-end.  The provision also increased as the real estate used as
collateral for these loans decline in value due to the economy.  The
Company believes that the allowance for loan and lease losses of $9.9 million,
or 2.03 percent of total loans at September 30, 2008, is adequate to cover
probable credit losses.
  The
Company’s net interest income increased $1.0 million or 21.2 percent during the
third quarter of 2008 as compared to the like quarter of 2007.  The
growth in net interest income was attributable to the Company’s loan growth
while the Company decreased interest expense by lowering rates paid on deposits
and borrowings.  The net interest spread increased to 3.39 percent
during the third quarter of 2008 as compared with 2.50 percent during the same
quarter of 2007.
  CRITICAL ACCOUNTING
POLICIES
  Certain
critical accounting policies involve estimates and assumptions made 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 Company’s accounting policies for the allowance for
loan and lease losses, securities other than temporarily impaired and other real
estate owned are critical as the Company’s management must make estimates of
valuations and these estimates are subject to change.
  Management
estimates impairment to its securities portfolio based on whether full payments
of a security’s principal and interest will be collected under the terms of the
security.  If a security is considered other than temporarily
impaired, the Company must write-down the affected security to its market value.
Where a market value is not readily available, FSP 157-3 allows the Company to
write-down the affected security by using a cash flow analysis using assumptions
as to expected payment streams.
  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, 2008 is adequate to cover probable incurred
credit losses.
   11
 Index
  NORTHERN STATES FINANCIAL
CORPORATION
  One of
the components of the allowance for loan losses is historical loss
experience.  Different loan classifications within the portfolio have
different loss experience ratios.  For example, loans secured by real
estate generally have a better loss experience than loans secured by other
assets.  Changes in the classification between periods can impact the
allocation for historical losses.  At September 30, 2008,
approximately 88 percent of the Bank’s loans were secured by real estate
compared with approximately 85 percent at December 31, 2007.
  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 depending on the adequacy
of the loan collateral and the borrowers’ ability to repay the
loans.  As specific allocations are done on a loan-by-loan basis, the
amount of the specific allocation is more likely subject to fluctuation than an
allocation for a pool of loans based on historical loss trends. The amount of
the allocations on 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 during the fourth quarter of each year.  Any such impairment
of goodwill would be recognized in that period.
  Other
intangible assets consist of core deposit and acquired customer relationship
intangible assets arising from whole bank and branch acquisitions, which is
periodically evaluated for impairment.  They are initially measured at
fair value and then are amortized on the straight-line method over their
estimated useful life of seven years.
  FINANCIAL
CONDITION
  The
Company’s cash and cash equivalents at September 30, 2008 were $57.0 million and
increased $33.4 million from December 31, 2007.  The Company had $42.9
million of federal funds sold at September 30, 2008 as compared with $9.2
million at December 31, 2007.  The Company’s growth in federal funds
sold resulted from efforts by the Company to increase its liquidity at
quarter-end.   Federal funds sold are excess funds above what is
necessary to maintain at the Federal Reserve that the Company lends/sells to
other financial institutions on an overnight basis.  Rather than
lend/sell these excess funds, the Company may use the funds for its liquidity
needs.
  The
Company’s securities available for sale declined $31.5 million to $121.8 million
at September 30, 2008 from $153.3 million at year-end 2007.  The
liquidity provided by the maturities and calls to the Company’s securities
available for sale during the nine months ended September 30, 2008 was used to
fund loan growth.  The Company had proceeds from the sales of
securities available for sale of $8.2 million during the third quarter of 2008
and recognized a gain of $40,000 from these sales.
  During
the third quarter of 2008 the Company incurred losses of $2.2 million due to the
write-down of securities available for sale that were considered to be other
than temporarily impaired.  The Company earlier in 2008 had purchased
Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage
Corporation (FHLMC) preferred stock totaling $2.1 million.  This
preferred stock became other than temporarily impaired when the U.S. Treasury
took over FNMA and FHLMC during the quarter, suspended dividend payments and
began to restructure these entities.  The Company recognized a $1.9
million loss in writing this preferred stock down to its fair
value.  The Company also took a $275,000 loss on bonds with a book
value of $10.8 million consisting of collateralized debt obligations due to the
other than temporarily impairment caused by defaults and deferral of payments by
the financial institutions and insurance companies issuing the underlying
debt.
   12
 Index
  NORTHERN STATES FINANCIAL
CORPORATION
 Loans and
leases, the largest earning asset of the Company, totaled $489.8 million at
September 30, 2008, increasing $54.1 million from $435.7 million at December 31,
2007.  The increase mainly came from increases in loans to the hotel
industry secured by commercial real estate.   The Company’s loans
to the hotel industry were $61.1 million at September 30, 2008, an increase of
$41.6 million from $19.5 million at December 31, 2007.
  The
Company’s loans are made primarily to small and midsize businesses and are
primarily secured by real estate.  Approximately 88 percent of the
Bank’s loan portfolio at September 30, 2008 was secured by real
estate.  There have been some declines in the real estate values in
our market area that have affected the collateral values of the Company’s loans
secured by real estate.  It should be noted that the Bank’s
underwriting standards require that borrowers have adequate cash flows in order
to support loan repayment.  As such, the Company carries no subprime
mortgages in its loan portfolio.  At September 30, 2008, approximately
$40.5 million of the Bank’s  1 – 4 family loans and home equity loans
were pledged under a blanket agreement to the Federal Home Loan Bank to secure
our borrowings and line of credit there.
  Loan
commitments have decreased $20.9 million to $115.8 million at September 30, 2008
compared with $136.7 million at December 31, 2007 as loans were drawn on and the
Bank tightened its credit requirements.  Letters of credit also
decreased at quarter-end to $9.1 million from $10.7 million at
year-end.  At September 30, 2008, loans to related parties totaled
$1.0 million and loan commitments and letters of credit issued to related
parties were $1.9 million.  Loans, loan commitments and letters of
credit to related parties are made on the same terms and conditions that are
available to the public.
  Deposits
at September 30, 2008 increased $12.2 million, or 2.5 percent, from year-end
2007.  The growth in deposits came mainly from increases in brokered
time deposits, which increased $34.3 million from December 31,
2007.  Other deposit types, other than brokered time deposits and time
deposits of $100,000 and greater, declined from year-end 2007 as the Bank had
lowered interest rates to increase its net interest
income.  Subsequent to September 30, 2008, the Bank increased its time
deposit rates and has a higher promotional money market rate in order to bring
in more deposits of these types.
  Securities
sold under repurchase agreements decreased by $14.8 million to $52.0 million at
September 30, 2008 from $66.8 million at December 31, 2007.  The
decline during 2008 was due to one customer who closed their $20.0 million
repurchase agreement relationship.  As the repurchase agreements
decreased and the Company increased its liquidity, the Company drew on its
Federal Home Loan Bank and federal funds purchased lines that totaled $35.0
million and $30.0 million, respectively, at September 30, 2008.
  As
previously disclosed, the Company has estimated environmental clean-up expenses
pertaining to a parcel of other real estate sold in previous years carried as an
other liability.  At September 30, 2008, this environmental liability
was carried in the amount of $298,000.  The Company intends to seek
reimbursement of these expenses from the State of Illinois that has a fund for
this type of cleanup.  However, there can be no assurance that the
Company will be successful in obtaining any such reimbursement.
  FAIR VALUE
MEASUREMENTS
  The
following tables present information about the Company’s securities that were
measured at fair value on a recurring basis at September 30, 2008, and the
valuation techniques used by the Company to determine the fair
values.
  In
general, fair values determined by Level 1 inputs use quoted prices in active
markets for identical securities that the Company has the ability to
access.
   13
 Index
  NORTHERN STATES FINANCIAL
CORPORATION
  Fair
values determined by Level 2 inputs use other inputs that are observable, either
directly or indirectly.  These Level 2 inputs include quoted prices
for similar securities in active markets, and other inputs such as interest
rates and yield curves that are observable at commonly quoted
intervals.
  Level 3
inputs are unobservable inputs, including inputs that are available in
situations where there is little, if any, market activity for the related
securities.
  In
instances where inputs used to measure fair value fall into different levels in
the above fair value hierarchy, fair value measurements in their entirety are
categorized based on the lowest level input that is significant to the
valuation. The Company’s assessment of the significance of particular inputs to
these fair value measurements requires judgment and considers factors specific
to each security.
  On an
annual basis the Company validates the measurement of the fair values of its
securities by sending a listing of its securities to an independent securities
valuation firm.  This independent securities valuation firm determines
the fair values of the Company’s securities portfolio that is then compared to
the fair value using the methods outlined.  When this validation was
last done at September 30, 2007, the difference between the fair value reported
and the fair value determined by the independent securities valuation firm was
considered insignificant.
  Disclosures
concerning securities measured at fair value are as follows:
  TABLE
1
  NORTHERN
STATES
FINANCIAL CORPORATION
  ASSETS
MEASURED AT FAIR VALUE ON A RECURRING BASIS
  As of
September 30, 2008
  ($
000s)
  Fair
      Value Measurements at Reporting Date UsingDescription
                
                9/30/08
                
                
                Quoted
      Prices in Active Markets for Identical Assets (Level
    1)
                
                
                Significant
      Other Observable Inputs (Level 2)
                
                
                Significant
      Unobservable Inputs (Level 3)Securities
      available for sale
                
                $
                121,822
                
                
                $
                —
                
                
                $
                111,297
                
                
                $
                10,525
 
 During
the third quarter of 2008, the Company used the Financial Accounting Standards
Board Staff Position No. 157-3 (“FSP 157-3”) to determine the fair value of its
investment in collateralized debt obligations that are backed by financial
institutions and insurance companies that had issued the debt.  The
methodology for determining fair value on these securities using FSP 157-3
changed the fair value measurement to a Level 3.  The Company used FSP
157-3 on these securities, as there were very few trades for these securities
and little relevant market data to determine a market value.
  The
Company used discounted cash flow analysis to determine the fair value of these
collateralized debt obligations that had an amortized cost of $10.8 million at
September 30, 2008.  These securities were transferred to a Level 3
and the Company realized a write-down of $275,000 as it was determined that a
portion of these collateralized debt obligations was other than temporarily
impaired as shown in Table 2.  Reasonable judgement was used that
carefully analyzed the defaults and deferral of payments by the financial
institutions and insurance companies that had issued the underlying
debt.
   14
 Index
  NORTHERN STATES FINANCIAL
CORPORATION
  TABLE
2
  NORTHERN
STATES
FINANCIAL CORPORATION
  CHANGES
IN LEVEL 3 ASSETS AND LIABILITIES
  MEASURED
AT FAIR VALUE ON A RECURRING BASIS
  As of
September 30, 2008
  ($
000s)
  Investment
      Securities Available-For-SaleBalance
      at December 31, 2007
                
                $
                0Total
      realized and unrealized gains (losses) included in income
                
                
                (275
                )Total
      unrealized gains (losses) included in other comprehensive
      income
                
                
                0Net
      purchase, sales, calls and maturities
                
                
                0Net
      transfer into Level 3
                
                
                10,800Balance
      at September 30, 2008
                
                $
                10,525
 
 The
Company also has assets that under certain conditions are subject to measurement
at fair value on a non-recurring basis. These assets are held to maturity loans
that are considered impaired per Financial Accounting Standard Board Statement
No. 114 (“FAS 114”).  The Company has estimated the fair values of the
impaired loans using Level 3 inputs, specifically discounted cash flow
projections.  For the quarter ended September 30, 2008, the Company’s
net change to its specific allocation to these impaired loans in order to adjust
these assets to their estimated fair values was $1,261,000.
    NORTHERN
STATES
FINANCIAL CORPORATION
  ASSETS
MEASURED AT FAIR VALUE ON A NON-RECURRING BASIS
  As of
September 30, 2008
  ($
000s)
  Fair
      Value Measurements at Report Date UsingDescription
                
                09/30/08
                
                
                Quoted
      Prices in Active Markets for Identical Assets
                    (Level
      1)
                
                
                Significant
      Other Observable Inputs
                    (Level
      2)
                
                
                Significant
      Unobservable Inputs
                    (Level
      3)
                
                
                Total
      Change for the quarter ended 09/30/08Impaired
      loans accounted For under FAS 114
                
                $
                19,651
                
                
                $
                —
                
                
                $
                —
                
                
                $
                19,651
                
                
                $
                1,261
   15
 Index
 NORTHERN STATES FINANCIAL
CORPORATION
 Impaired
loans that are accounted for under FAS 114 are categorized as Level 3 for fair
value measurement.  The Company estimates the fair value of these
loans are based on the present value of expected future cash flows using
management’s best estimate of key assumptions.  These assumptions
include future payment ability, timing of payment streams, and estimated net
realizable values of available collateral (typically based on outside
appraisals).
  Other
assets, including goodwill, intangible assets and other assets acquired in
business combinations, are also subject to periodic impairment assessments under
other accounting principles generally accepted in the United States of America.
These assets are not considered financial instruments.  Effective
February 12, 2008, the FASB issued a staff position, FSP FAS 157-2, which
delayed the applicability of FAS 157 to non-financial
instruments.  Accordingly, these assets are not included for purposes
of the above disclosures.
  CAPITAL
  Total
stockholders’ equity decreased $5.4 million to $68.0 million during the nine
months ended September 30, 2008.  Items causing a reduction to
stockholders’ equity were a net loss of $1,730,000 for the nine months ended
September 30, 2008, purchases of 105,850 shares of treasury stock for $2,078,000
and a payment of a $.40 per share cash dividend to stockholders on June 1, 2008
that totaled $1,628,000.  Stockholders’ equity was increased by $5,000
from the change in the accumulated other comprehensive income due to unrealized
gains on securities available for sale, net of deferred tax during the first
nine months of 2008.  The book value of the Company’s common stock at
September 30, 2008 was $16.70 per share.
  On a
consolidated basis, the Company’s Tier 1 to total assets ratio and total capital
to assets ratio, on a risk adjusted basis, were 11.69 percent and 12.95 percent,
respectively, at September 30, 2008 and exceed the regulatory minimum for
capital adequacy purposes for bank holding companies of 4.00 percent an 8.00
percent.  The Bank’s total capital to assets ratio, at
September 30, 2008, on a risk adjusted basis, were 11.62 percent and 12.87
percent, respectively, and exceed the regulatory minimum to be considered
“well-capitalized” of 6.00 percent an 10.00 percent.  Management
believes that the capital position of the Company is appropriate for current
projected needs.
  LIQUIDITY
  The
Company’s liquidity is measured by the ability to raise funds through deposits,
borrowed funds, capital or cash flow from the repayment or maturities of loans
and securities and net profits.   Liquidity is primarily managed through
the growth of deposits and by liquid assets such as cash and due from banks less
any reserve requirements, securities available for sale less any pledged
securities and federal funds sold.  Asset and liability management is the
process of managing the balance sheet to achieve a mix of earning assets and
liabilities in such a way that achieves an interest rate risk profile acceptable
to management and assists in achieving a desired level of profitability.
 An important part of the overall asset and liability management process is
providing adequate liquidity.  Liquid assets at the Bank consist of
cash and equivalents less any Federal Reserve Bank deposit requirements plus
unpledged securities available for sale.  The Bank’s liquid assets
totaled $81.6 million at September 30, 2008 as compared with $46.5 million at
December 31, 2007.
  Management
reviews the liquidity ratio as well as its sources and uses of funds
periodically.  The liquidity ratio is the net liquid assets divided by
net deposits and short-term liabilities.  At September 30, 2008, this
ratio at the Bank was 15.70 percent, and was within management’s internal policy
guidelines.
   16
 Index
  NORTHERN STATES FINANCIAL
CORPORATION
  Liquidity
management involves the Company’s ability to meet the cash flow requirements of
customers.  The Company needs to have sufficient cash flow to meet borrowers’ needs
to fund loans and the requirements of depositors wanting to withdraw
funds.  The statements of cash flows shows that for the nine months
ended September 30, 2008 cash and cash equivalents increased by $33.4 million to
$57.0 million.
  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 were $42.9 million at September 30,
2008 as compared with $9.2 million at December 31, 2007.  The Company
classifies all of its securities as available for sale, which increases the
Company's flexibility in that the Company can use its unpledged securities to
meet liquidity requirements by increasing its repurchase agreement
balances.  Securities available for sale totaled $121.8 million at
September 30, 2008 of which $92.6 million were pledged to secure public deposits
and repurchase agreements as compared with pledged securities
of  $125.3 million at December 31, 2007.
  The
Company can sell unpledged securities for liquidity purposes prior to their
maturity date.  During the nine months ended September 30, 2008, the
Company sold securities with a book value of $8.2 million for liquidity purposes
and recognized a gain of $40,000 from the sales.
  During
the first nine months of 2008, the Company had incoming cash flows from
maturities and calls of securities available for sale of $83.4 million while it
had cash outflows for purchases of securities of $62.2 million.  These
securities activities during the first nine months of 2008 provided liquidity of
$21.2 million, which was used to help meet the cash flows for funding
loans.
  An
important source of liquidity to the Company is deposits.  The Company
may use brokered deposits as a source of liquidity.  During the nine
months ended September 30, 2008 increased its brokered deposits by $34.3 million
to $78.1 million, amounting to 15.8 percent of total deposits, to meet the
Company’s liquidity needs.  Subsequent to September 30, 2008, the
Company took in an additional $15.5 million in brokered deposits for liquidity
purposes.
  Another
important source of liquidity to the Company is borrowings in the form of
repurchase agreements and Federal Home Loan Bank advances.  During the
nine months ended September 30, 2008, borrowings through repurchase agreements
decreased $14.8 million as one repurchase agreement relationship of $20.0
million was closed.  The Company is carrying $35.0 million at
September 30, 2008 in Federal Home Loan Bank (“FHLB”) advances.  In
order to increase its line of credit available from the FHLB, the Company
increased its investment in FHLB stock by $312,000 during the first nine months
of 2008.  The Company has made a blanket pledge of its 1-4 family and
home equity loans totaling $40.5 million to the FHLB for this credit line as
well.
  The
Company also uses short-term borrowings for federal funds purchased to assist
its liquidity needs.  At September 30, 2008, the Company had overnight
borrowings of federal funds purchased totaling $30.0 million from independent
banks.  An additional $15.0 million was available from these
independent banks at September 30, 2008 to meet the Company’s funding needs,
including any unexpected strain on liquidity.  To further increase its
borrowing capacity, the Company is applying for a line of credit at the Federal
discount window and expects to have a line of credit available there during the
fourth quarter of 2008 of approximately $25.0 million.
  RESULTS OF
OPERATIONS
  NET
INCOME
  The
Company posted a net loss of $2,781,000 for the quarter ended September 30, 2008
as compared with net income of $581,000, for the same quarter of
2007.  Despite growth of  $1.0 million to net interest
income for the third quarter ended September 30, 2008, an increase in its
provision for loan and
   17
 Index
  NORTHERN STATES FINANCIAL
CORPORATION
  lease
losses of $5.1 million and write-downs to securities of $2.2 million resulted in
the Company recording a net loss for the period.
  For the
nine months ended September 30, 2008, the Company showed a loss of $1,730,000 as
compared with net income of $3,157,000 for the same nine months of
2007.  The decrease in net income for the nine months ended September
30, 2008 was due to the provision for loan and lease losses of $8.1 million
necessitated by increased levels of nonperforming loans as economic conditions
have negatively impacted all sectors of the real estate
market.  During the first nine months of 2007, the Company had a
reduction of $458,000 to its provision for loan and lease losses as improvements
were made to the Company’s nonperfoming loan portfolio.  The Company
also recognized a $2.2 million write-down to its securities during the nine
months ended September 30, 2008 while there had been no security write-downs in
2007.
  NET
INTEREST INCOME
  Net
interest income, the difference between interest income on earning assets and
interest expense on interest bearing liabilities, increased 21.2 percent to $5.7
million for the third quarter of 2008, an increase of $1.0 million as compared
with $4.7 million for the same quarter of 2007.  The growth to net
interest income was attributable to increased interest income from loan growth
while the Company significantly decreased interest expense by lowering rates
paid on deposits and borrowings.
  Interest
income from earning assets during the third quarter of 2008 declined $725,000
from the same quarter last year.  The lower volume of interest earning
assets coupled with generally lower interest rates during the third quarter of
2008 as compared to the same quarter of 2007 account for this
decrease.   Table 4 shows that average interest earning assets
were $609.5 million during the third quarter of 2008, $7.5 million less as
compared with $617.0 million during the same quarter of
2007.  However, average loans, the interest earning asset that
generally yield the highest rate of interest for the Company, were $95.1 million
greater in the third quarter of 2008 than for the same quarter of
2007.  Corresponding loan interest income on a fully tax equivalent
basis was $227,000 greater during the third quarter of 2008 than for the same
quarter last year.  General interest rates were lower as evidenced by
the prime lending rate, which was 5.00 percent at September 30, 2008, as
compared with 7.75 percent at September 30, 2007.  The effect of the
lower interest rates is evidenced in Table 4 that shows that yields earned on
average interest earning assets declined 42 basis points to 5.89 percent during
the third quarter of 2008 as compared with 6.31 percent for the like quarter of
2007.
  Interest
expense declined $1.7 million in the third quarter of 2008 as compared with the
same quarter of 2007.  Interest expense declined as the volume of
average interest bearing liabilities decreased during the third quarter of 2008
by $4.1 million to $514.7 million compared with $518.8 million during the same
period of 2007.  During 2007 and into 2008, in order to lower its
interest expense, the Company began offering lower rates on its deposit products
even though this caused some decline to deposit balances.  The effect
of this strategy is evidenced during the third quarter of 2008 where rates paid
on interest bearing liabilities declined 131 basis points to 2.50 percent as
compared with 3.81 percent for the same quarter of 2007.
  The net
interest rate spread increased 89 basis points to 3.39 percent for the third
quarter of 2008 compared to 2.50 percent for the same quarter of
2007.  The increased net interest spread shows that yields on interest
earning assets declined at a much slower speed than the decreases to rates paid
on interest bearing liabilities.
  Table 5
shows that during the nine months ended September 30, 2008, net interest income
on a fully tax equivalent basis increased $3.6 million compared with the same
period of 2007.  Average yields on interest earning assets declined 4
basis points to 6.02 percent during the nine months ended September 30, 2007 as
compared with the same nine months last year while average rates paid on
interest bearing liabilities decreased by 109 basis points, causing the growth
to the net interest spread.
   18
 Index
  NORTHERN STATES FINANCIAL
CORPORATION
  TABLE
4
  NORTHERN
STATES FINANCIAL CORPORATION
  ANALYSIS
OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
  For the
Three Months Ended September 30, 2008 and 2007 – Rates are
Annualized
  ($
000s)
  2008
                    
                    
                    2007Average
      Balance
                    
                    
                    Interest
                    
                    
                    Rate
                    
                    
                    Average
      Balance
                    
                    
                    Interest
                    
                    
                    RateAssetsLoans(1)(2)(3)
                    
                    $
                    485,366
                    
                    
                    $
                    7,308
                    
                    
                    
                    6.02
                    %
                    
                    $
                    390,223
                    
                    
                    $
                    7,081
                    
                    
                    
                    7.26
                    %Taxable
      securities(4)
                    
                    
                    110,136
                    
                    
                    
                    1,544
                    
                    
                    
                    5.40
                    %
                    
                    
                    197,623
                    
                    
                    
                    2,283
                    
                    
                    
                    4.60
                    %Tax
      advantaged securities(2)(4)
                    
                    
                    11,627
                    
                    
                    
                    183
                    
                    
                    
                    6.23
                    %
                    
                    
                    7,684
                    
                    
                    
                    109
                    
                    
                    
                    5.66
                    %Federal
      funds sold
                    
                    
                    2,351
                    
                    
                    
                    8
                    
                    
                    
                    1.36
                    %
                    
                    
                    21,496
                    
                    
                    
                    271
                    
                    
                    
                    5.04
                    %Interest
      earning assets(4)
                    
                    
                    609,480
                    
                    
                    
                    9,043
                    
                    
                    
                    5.89
                    %
                    
                    
                    617,026
                    
                    
                    
                    9,744
                    
                    
                    
                    6.31
                    %Noninterest
      earning assets
                    
                    
                    38,961
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    39,539Average
      assets
                    
                    $
                    648,441
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    656,565Liabilities
      and stockholders’ equityNOW
      deposits
                    
                    $
                    44,636
                    
                    
                    $
                    38
                    
                    
                    
                    0.34
                    %
                    
                    $
                    46,447
                    
                    
                    $
                    101
                    
                    
                    
                    0.87
                    %Money
      market deposits
                    
                    
                    65,026
                    
                    
                    
                    280
                    
                    
                    
                    1.72
                    %
                    
                    
                    75,873
                    
                    
                    
                    696
                    
                    
                    
                    3.67
                    %Savings
      deposits
                    
                    
                    62,362
                    
                    
                    
                    78
                    
                    
                    
                    0.50
                    %
                    
                    
                    64,523
                    
                    
                    
                    123
                    
                    
                    
                    0.76
                    %Time
      deposits
                    
                    
                    250,197
                    
                    
                    
                    2,263
                    
                    
                    
                    3.62
                    %
                    
                    
                    248,264
                    
                    
                    
                    3,017
                    
                    
                    
                    4.86
                    %Other
      borrowings
                    
                    
                    92,453
                    
                    
                    
                    553
                    
                    
                    
                    2.39
                    %
                    
                    
                    83,715
                    
                    
                    
                    1,007
                    
                    
                    
                    4.81
                    %Interest
      bearing liabilities
                    
                    
                    514,674
                    
                    
                    
                    3,212
                    
                    
                    
                    2.50
                    %
                    
                    
                    518,822
                    
                    
                    
                    4,944
                    
                    
                    
                    3.81
                    %Demand
      deposits
                    
                    
                    58,343
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    57,308Other
      noninterest bearing liabilities
                    
                    
                    6,676
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    7,589Stockholders’
      equity
                    
                    
                    68,748
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    72,846Average
      liabilities and stockholders’ equity
                    
                    $
                    648,441
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    656,565Net
      interest income
                    
                    
                    
                    
                    
                    $
                    5,831
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    4,800Net
      interest spread
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.39
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    2.50
                    %Net
      yield on interest earning assets(4)
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.80
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.11
                    %Interest-bearing
      liabilities to earning assets ratio
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    84.44
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    84.08
                    %
 _______________
 (1)
              -
      Interest income on loans includes loan origination and other fees of
      $61,000 and $71,000 for the three months ended September 30, 2008 and
      2007.
 (2)
              -
      Tax-exempt income is reflected on a fully tax equivalent basis utilizing a
      34 percent tax rate.  The tax equivalent adjustment reflected in
      the above table for municipal loans is approximately $21,000 and $22,000
      for the three months ended September 30, 2008 and 2007.  The tax
      equivalent adjustment reflected in the above table for tax advantaged
      securities is approximately $62,000 and $37,000 for the three months ended
      September 30, 2008 and 2007.
 (3)
              -
      Non-accrual loans are included in average
loans.
 (4)
              -
      Rate information was calculated on the average amortized cost for
      securities.  The three months ended September 30, 2008 and 2007
      average balance information includes an average unrealized gain (loss) for
      taxable securities of ($4,229,000) and ($790,000) and for tax-advantaged
      securities of ($118,000) and
($20,000).






19
 Index




NORTHERN STATES FINANCIAL
CORPORATION
  TABLE
5
  NORTHERN
STATES FINANCIAL CORPORATION
  ANALYSIS
OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
  For the
Nine Months Ended September 30, 2008 and 2007 - Rates are
Annualized
  ($
000s)
  2008
                
                
                2007Average
      Balance
                
                
                Interest
                
                
                Rate
                
                
                Average
      Balance
                
                
                Interest
                
                
                RateAssetsLoans(1)(2)(3)
                
                $
                464,994
                
                
                $
                21,651
                
                
                
                6.21
                %
                
                $
                379,307
                
                
                $
                20,512
                
                
                
                7.21
                %Taxable
      securities(4)
                
                
                124,842
                
                
                
                5,137
                
                
                
                5.44
                %
                
                
                227,445
                
                
                
                7,262
                
                
                
                4.23
                %Tax
      advantaged securities(2)(4)
                
                
                11,199
                
                
                
                526
                
                
                
                6.25
                %
                
                
                7,702
                
                
                
                324
                
                
                
                5.60
                %Federal
      funds sold
                
                
                4,627
                
                
                
                91
                
                
                
                2.62
                %
                
                
                18,660
                
                
                
                751
                
                
                
                5.37
                %Interest earning assets(4)
                
                
                605,662
                
                
                
                27,405
                
                
                
                6.02
                %
                
                
                633,114
                
                
                
                28,849
                
                
                
                6.06
                %Noninterest
      earning assets
                
                
                37,693
                
                
                
                
                
                
                
                
                
                
                
                41,031Average
      assets
                
                $
                643,355
                
                
                
                
                
                
                
                
                
                
                $
                674,145Liabilities
      and stockholders’ equityNOW
      deposits
                
                $
                45,402
                
                
                $
                117
                
                
                
                0.34
                %
                
                $
                48,555
                
                
                $
                299
                
                
                
                0.82
                %Money
      market deposits
                
                
                67,980
                
                
                
                925
                
                
                
                1.81
                %
                
                
                76,373
                
                
                
                2,168
                
                
                
                3.78
                %Savings
      deposits
                
                
                62,496
                
                
                
                246
                
                
                
                0.52
                %
                
                
                66,259
                
                
                
                374
                
                
                
                0.75
                %Time
      deposits
                
                
                249,073
                
                
                
                7,541
                
                
                
                4.04
                %
                
                
                253,906
                
                
                
                9,205
                
                
                
                4.83
                %Other
      borrowings
                
                
                82,361
                
                
                
                1,644
                
                
                
                2.66
                %
                
                
                92,497
                
                
                
                3,431
                
                
                
                4.95
                %Interest bearing liabilities
                
                
                507,312
                
                
                
                10,473
                
                
                
                2.75
                %
                
                
                537,590
                
                
                
                15,477
                
                
                
                3.84
                %Demand
      deposits
                
                
                57,411
                
                
                
                
                
                
                
                
                
                
                
                56,750Other
      noninterest bearing liabilities
                
                
                7,030
                
                
                
                
                
                
                
                
                
                
                
                7,761Stockholders’
      equity
                
                
                71,602
                
                
                
                
                
                
                
                
                
                
                
                72,044Average
      liabilities and stockholders’ equity
                
                $
                643,355
                
                
                
                
                
                
                
                
                
                
                $
                674,145Net
      interest income
                
                
                
                
                
                $
                16,932
                
                
                
                
                
                
                
                
                
                
                $
                13,372Net
      interest spread
                
                
                
                
                
                
                
                
                
                
                3.27
                %
                
                
                
                
                
                
                
                
                
                
                2.22
                %Net
      yield on interest earning assets(4)
                
                
                
                
                
                
                
                
                
                
                3.72
                %
                
                
                
                
                
                
                
                
                
                
                2.81
                %Interest-bearing
      liabilities to earning assets ratio
                
                
                
                
                
                
                
                
                
                
                83.76
                %
                
                
                
                
                
                
                
                
                
                
                84.91
                %
 _______________
 (1)
              -
      Interest income on loans includes loan origination and other fees of
      $156,000 and $327,000 for the nine months ended September 30, 2008
      and 2007.
 (2)
              -
      Tax-exempt income is reflected on a fully tax equivalent basis utilizing a
      34 percent tax rate.  The tax equivalent adjustment reflected in
      the above table for municipal loans is approximately $66,000 and $57,000
      for the nine months ended September 30, 2008 and 2007.  The tax
      equivalent adjustment reflected in the above table for tax advantaged
      securities is approximately $179,000 and $110,000 for the nine months
      ended September 30, 2008 and 2007.
 (3)
              -
      Non-accrual loans are included in average
loans.
 (4)
              -
      Rate information was calculated on the average amortized cost for
      securities.  The nine months ended September 30, 2008 and 2007
      average balance information includes an average unrealized gain (loss) for
      taxable securities of ($1,501,000) and ($1,434,000) and for tax-advantaged
      securities of ($20,000) and
($6,000).
   20
 Index
  NORTHERN STATES FINANCIAL
CORPORATION
 Subsequent
to September 30, 2008, the prime lending rate decreased 50 basis points to 4.50
percent and the Company has increased its time deposit rates and increased its
promotional rate on money market accounts.  A majority of its loans
are at fixed rates and the Company believes that it will maintain the yields
earned on these loans as prepayment penalties will deter borrowers from
refinancing many of these loans.  A portion of the Company’s variable
rate loans have interest rate floors that do not allow the loan yield to
decrease any further.  However, in considering these factors,
management believes that the net interest spread may begin to contract slightly
during the fourth quarter of 2008.
  ASSET
QUALITY AND THE PROVISION FOR LOAN AND LEASE LOSSES
  At
September 30, 2008, management, with the concurrence of the Board of Directors,
after carefully reviewing the adequacy of the allowance for loan and lease
losses and the levels of nonperforming and impaired loans and leases, determined
that an allowance of $9.9 million was adequate to cover probable incurred loan
and lease losses as compared with $4.6 million at year-end
2007.  During the nine months ended September 30, 2008, $2.9 million
in loans and leases were charged off against the allowance compared with charge
offs of $2.6 million during the same period last year.  Recoveries of
loans previously charged off during the nine months ended September 30, 2008
totaled $73,000 as compared with $50,000 in recoveries during the same period in
2007.  During the third quarter of 2008, the provision for loan and
lease losses was $5.1 million and the provision for the nine months ended
September 30, 2008 totaled $8.1 million.  There was a provision for
loan and lease losses during the third quarter of 2007 for $1.0 million and for
the nine months ended September 30, 2007 the provision was a net reduction of
$458,000.
  TABLE
6
  NORTHERN
STATES FINANCIAL CORPORATION
  NONPERFORMING
ASSETS
  ($
000’s)
  September
      30, 2008
                      
                      
                      December
      31, 2007Loans
      and leasesNonaccrual
      status
                      
                      $
                      19,651
                      
                      
                      $
                      10,75290
      days or more past due, still accruing
                      
                      
                      8,163
                      
                      
                      
                      1,230Total
      nonperforming loans and leases
                      
                      
                      27,814
                      
                      
                      
                      11,982Other
      real estate owned
                      
                      
                      4,636
                      
                      
                      
                      2,857Total
      nonperforming assets
                      
                      $
                      32,450
                      
                      
                      $
                      14,839Nonperforming
      loans and leases as a percentage of total loans, net of unearned income
      and deferred loan fees
                      
                      
                      5.68
                      %
                      
                      
                      2.75
                      %Nonperforming
      assets as a percentage of total assets
                      
                      
                      4.67
                      %
                      
                      
                      2.33
                      %Nonperforming
      loans and leases as a Percentage of the allowance for loan
      losses
                      
                      
                      280.04
                      %
                      
                      
                      260.14
                      %
 
 Nonperforming
loans and leases, which includes loans and leases on nonaccrual status in
addition to loans and leases 90 days or more past due and still accruing
interest, were $27.8 million at September 30, 2008, or 5.68 percent of total
loans and leases, as compared with $12.0 million at December 31, 2007, or 2.75
percent of loans and leases.
   21
 Index
 NORTHERN STATES FINANCIAL
CORPORATION
 At
September 30, 2008, loans on nonaccrual status totaled $19.7 million as compared
with $10.8 million at year-end 2007.  Although the Company had
received loan payoffs and payments that reduced nonaccrual loans carried at
December 31, 2007 by $6.5 million, additional loans were put on nonaccrual
status during the nine months ended September 30, 2008. The major additions to
nonperforming loans during the nine months ended September 30, 2008 that were
placed on nonaccrual status include a $9.0 million loan on a renovated luxury
home, two construction loans for $2.0 million and $1.7 million, loans totaling
$1.1 million to a borrower secured by commercial properties and a $2.1 million
home equity loan.
  The $9.0
million loan placed on nonaccural status in 2008 is secured by a luxury home on
7.5 acres that had been extensively renovated by the borrower.  The
loan was placed on nonaccrual status, as the borrower has been unable to sell
the property.  The Company allocated $2.3 million of its allowance for
loan and lease losses specifically to this loan at September 30,
2008.
  A
construction loan in the amount of $2.0 million for four luxury condominiums was
placed on nonaccrual as the project experienced delays and the borrower’s
general contractor declared bankruptcy.  The project is expected to be
completed and the units sold.  The loan is expected to be paid off in
full from the sale proceeds and as such the Company has not allocated any of its
allowance for loan and lease losses specifically to this loan.
  A loan
for the construction of 145 condominiums in Texas, in which the Bank is a
participant with the Bank’s portion of the loan at $1.7 million at September 30,
2008, was placed on nonaccrual status during 2008.  Structural
problems have delayed the completion of the building.  At September
30, 2008, the Company has allocated $830,000 of its allowance for loan and lease
losses specifically to this loan.  As more information is made
available from the project’s engineers as to the structural problems and the
cost to correct them, the allowance allocated to this loan may be
adjusted.
  Additional
loans totaling $1.1 million secured by business properties were also placed on
nonaccrual status during 2008 as the borrower experienced cash flow
difficulties.  There have been declines to the market value of the
properties securing the loans and the Company has allocated $153,000 of its
allowance for loan and lease losses to these loans at September 30,
2008.
  A home
equity loan secured by a luxury home in the amount of $2.1 million was placed on
nonaccrual status during 2008 as the borrower had experienced cash flow
problems.  The Company has allocated $635,000 of its allowance for
loan and lease losses to these loans at September 30, 2008 as the value of the
property has deteriorated.
  Loans 90
days or more past due and still accruing interest is another component of
nonperforming loans and totaled $8.2 million at September 30, 2008, an increase
of  $7.0 million from $1.2 million at December 31,
2007.  The increase comes from one borrower with loans totaling $7.8
million that are 90 days or more past due and still accruing.  The
borrower has experienced cash flow problems from the commercial properties
securing the loans.  This relationship is in the process of collection
as the borrower is attempting to sell some of the properties to pay down the
loan balances and bring the remaining loans up to date.
  Impaired
loans and leases at September 30, 2008 totaled $19.7 million as compared with
$10.8 million at December 31, 2007.  The Company considers a loan or
lease impaired if full principal and interest will not be collected under the
contractual terms of the note.  Nonaccrual loans and leases are
classified as impaired.  Impaired loans and leases are carried at the
present value of expected cash flows discounted at the loan’s effective interest
rate or at the fair value of the collateral less selling costs, if the loan or
lease is collateral dependent.  At September 30, 2008, $4.6 million of
the allowance for loan and lease losses was allocated to the impaired
loans.
   22
 Index
  NORTHERN STATES FINANCIAL
CORPORATION
 Another
component of nonperforming assets is other real estate owned, consisting of
assets acquired through loan foreclosure and repossession. At September 30,
2008, other real estate owned totaled $4.6 million at September 30, 2008,
increasing $1.70 million from $2.9 million at December 31, 2007.  The
fair value of other real estate owned is reviewed by management at least
quarterly to help ensure the reasonableness of its carrying value, which is the
lower of cost or the fair value less estimated selling costs.
  The
carrying value of other real estate increased during the third quarter of 2008
primarily as 5 single-family properties securing loans were foreclosed upon and
were transferred to other real estate owned.   These properties
consist of 5 single family homes that the Company is attempting to
sell.
  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 $1,923,000 at September 30,
2008.  The Company is attempting to sell this property through the
Bank’s subsidiary, Northern States Community Development Corporation as part of
the City of Waukegan’s lakefront development plans.  A problem with
the development of this real estate is the need to move railroad tracks that are
adjacent to the property.  The City of Waukegan has been in
negotiations with the railroad to move these tracks as part of the city’s
Lakefront Downtown Master Plan.
  This
property is a former commercial/industrial site and environmental remediation
costs may be incurred in disposing of this property.  As of December
31, 2007, an independent environmental consultant’s opinion was that it would
cost approximately $1,600,000 to achieve acceptable levels of contaminants for
commercial/industrial or residential land use and to prevent migration of
contaminants to adjoining off-site properties and Lake
Michigan.  During the nine months ended September 30, 2008, $213,000
of environmental cleanup was incurred that increased the carrying value of the
property.  No determination has yet been made as to the ultimate end
use of the property, which would need to be approved by the City of Waukegan as
part of its Lakefront Downtown Master Plan. The appraised value of the property
supports the Company’s carrying value plus the estimated remaining remediation
costs and as such, at this time no liability has been recorded for these
estimated environmental remediation costs.
  At
September 30, 2008, the Company is also carrying $1.2 million as other real
estate owned on a property consisting of a two-story office building in
Waukegan, Illinois that had been transferred to other real estate owned in
2004.  The Company is actively attempting to sell this
property.
  NONINTEREST
INCOME
  The
Company’s noninterest income for the three months ended September 30, 2008
showed a loss of $1.0 million.  For the same quarter of 2008, the
Company showed noninterest income of  $1.2
million.   The reason for the loss in the third quarter of 2008
was that the Company took a $2.2 million write-down to its securities due to
some securities being classified as other than temporarily
impaired.
  The
write-down of securities of $2.2 million caused noninterest income to decline
for nine months ended September 30, 2008 by $2.5 million as compared to the same
period of 2007.  Service fees on deposits were $140,000 less during
the nine months ended September 30, 2008 due to decreases to overdraft fee
income.  Other operating income was $269,000 lower during the nine
months ended September 30, 2008 as mortgage banking service fee income was
$102,000 less than during the same time period of 2007.  In addition
the Company recognized a one-time gain of $148,000 from the sale of the Bank’s
land trust area during the nine months ended September 30, 2007.
   23
 Index
 NORTHERN STATES FINANCIAL
CORPORATION
 NONINTEREST
EXPENSE
  Noninterest
expense for the quarter ended September 30, 2008 was $4.2 million, unchanged
from the same quarter of 2007.  In comparing noninterest expenses for
the third quarter of 2008 to the same quarter of 2007, salaries and employee
benefits increased $30,000, occupancy and equipment expenses increased by
$32,000 and data processing increased by $26,000.  These expenses were
largely offset by decreases of $73,000 to audit and other professional
expenses.  Salaries and employee benefits expense increased, in part,
due to the addition to staff of a President of the Bank where in the past the
Chairman of the Board performed this function.
  Noninterest
expense for the nine months ended September 30, 2008 totaled $13.0 million,
increasing $92,000 from the same period of 2007.  During the nine
months ended September 30, 2008, there were increases to other operating
expenses of $194,000, to audit and other professional fees of $80,000 and data
processing expense of $62,000.  Other operating expenses increased as
expenses relating to nonperforming assets increased $112,000 and FDIC insurance
expense increased $51,000.  The expenses relating to nonperforming assets and
FDIC insurance are expected to continue to grow in future quarters. These
increases were partially offset by improvements to salaries and employee
benefits expense, which decreased by $114,000, legal expense, which decreased by
$67,000, and printing and supplies which decreased by
$62,000.  Salaries and employee benefits have declined as the number
of average full time equivalent employees were reduced by 5 during the nine
months ended September 30, 2008 as compared with the same period of
2007.  Legal expense decreased as one of the Bank’s major
nonperforming loans was settled during the first quarter of 2008.  As
nonperforming loans have risen in 2008, it is expected that legal expense is
expected to increase in future quarters.
  FEDERAL
AND STATE INCOME TAXES
  For the
three months ended September 30, 2008, the Company had a tax benefit of
$1,847,000 as compared with income taxes of $183,000 for the same three months
last year.  The tax benefit resulted from the pretax loss of $4.6
million during the third quarter of 2008.  The write-down of $1.9
million of the FNMA and FHLMC preferred stock during the third quarter of 2008
was a capital loss that required an  offset by capital gains in order
for a tax benefit to be booked from it.  The tax law was changed in
early October 2008 to treat the write-down as ordinary income that need not be
offset by a capital gain.  At September 30, 2008, the Company had a
strategy to recognize an offsetting capital gain but the change in the tax law
negated the need for this strategy.
  The
Company had a tax benefit of $1.4 million for the nine months ended September
30, 2008 as compared with a tax expense of $1.4 million for the same period of
2007.  The tax benefit resulted from the pretax loss of $3.2 million
during the nine months ended September 30, 2008.  The pretax loss was
primarily due to the provision for loan and lease losses of $8.6 million and
write-down of securities of $2.2 million.
  CONTRACTUAL
OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
  The
Company has contractual obligations that may not appear on the balance
sheet.  Table 7 presents the Company’s significant fixed and
determinable contractual obligations as of September 30, 2008, by payment date.
The payment amounts in Table 7 represent those amounts contractually due to the
recipient and do not include any unamortized premiums or discounts or similar
carrying amount adjustments.
 24
 Index
 NORTHERN STATES FINANCIAL
CORPORATION
 TABLE
7
  NORTHERN
STATES
FINANCIAL CORPORATION
  CONTRACTUAL
OBLIGATIONS
  As of
September 30, 2008
  ($
000s)
  Contractual
      obligations
                          
                          One
      year or less
                          
                          
                          Greater
      than 1 yr. and less than
      or equal to 3 yrs.
                          
                          
                          Greater
      than 3 yrs. and less than or equal to 5 yrs.
                          
                          
                          Greater
      than 5 yrs.
                          
                          
                          TotalLong-term
      debtFederal
      Home Loan Bank advances
                          
                          $
                          35,000
                          
                          
                          $
                          0
                          
                          
                          $
                          0
                          
                          
                          $
                          0
                          
                          
                          $
                          35,000Subordinated
      debentures
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          10,000
                          
                          
                          
                          10,000Time
      deposits
                          
                          
                          215,505
                          
                          
                          
                          60,393
                          
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          275,898Other
      contractual obligationsStandby
      letters of credit
                          
                          
                          9,078
                          
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          9,078Community
      Reinvestment Act investment commitment
                          
                          
                          51
                          
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          51
 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
  The
Company’s primary market risk exposure is interest rate risk and, to a lesser
extent, liquidity risk. Interest rate risk is the exposure of a banking
organization’s financial condition to adverse movements in interest
rates.  The Company seeks to achieve consistent growth in net interest
income and net income while managing volatility that arises from shifts in
interest rates.   The Company’s Asset and Liability Management
Committee (“ALCO”) oversees interest rate risk programs instituted by management
and measurements of interest rate risk to determine that they are within
authorized limits set by the Company’s Board of Directors.
  Evaluating
a financial institution’s exposure to changes in interest rates includes
assessing both the adequacy of the management process used to control interest
rate risk and the organization’s quantitative level of exposure.  When
assessing the interest rate risk management process, the Company seeks to ensure
that appropriate policies, procedures, management information systems and
internal controls are in place to maintain interest rate risk at prudent levels
with consistency and continuity.  Evaluating the quantitative level of
interest rate risk exposure requires the Company to assess the existing and
potential future effects of changes in interest rates on its consolidated
financial condition, including capital adequacy, earnings, liquidity, and, where
appropriate, asset quality.
  The
primary approach used by management to analyze interest rate risk is to
periodically evaluate the “shock” to net interest income of an assumed
instantaneous decrease and increase in rates of 1% and 2% using computer
simulation to show the effect of rate changes on the base 12 month projected net
interest income.  This approach falls under the broad definition of
asset/liability management.
   25
 Index
 NORTHERN STATES FINANCIAL
CORPORATION
  Several
ways the Company can manage interest rate risk include: selling existing assets
or repaying certain liabilities and matching repricing periods for new assets
and liabilities, for example, by shortening terms of new loans or
securities.  Financial institutions are also subject to prepayment
risk in a falling rate environment.  For example, a debtor may prepay
financial assets so that the debtor may refinance obligations at new, lower
rates.  Prepayments of assets carrying higher rates reduce the
Company’s interest income and overall asset yields.  The Company
attempts to lessen prepayment risk by having prepayment penalties on commercial
purpose loans.  A large portion of an institution’s liabilities may be
short term or due on demand, while most of its assets may be invested in
longer-term loans or securities. Accordingly, the Company seeks to have in place
sources of cash to meet short-term demands.  These funds can be
obtained by increasing deposits, borrowing, or selling assets.
  Financial
institutions are also subject to interest rate risk in a rising rate
environment.  Call features on securities may not be exercised and
lower yielding securities may remain in the Company’s securities portfolio until
maturity.
  Table 8
shows how interest rate shocks of decreasing rates 1% and 2% and increasing
rates 1% and 2% affect projected 12 month projected net interest income at
September 30, 2008 and December 31, 2007.  The computer simulation
model used to do the interest rate shocks and calculate the effect on projected
net interest income takes into consideration maturity and repricing schedules of
the various assets and liabilities as well as call provisions on the Company’s
securities.
  At
September 30, 2008 the projected net interest income increases $116,000 when
rates are shocked upward 2% while projected net interest income decreases
$258,000 for a 2% downward rate shock.   At December 31, 2007
projected net interest income increased $418,000 when rates were shocked upward
2% while projected net interest income decreased by $222,000, for a 2% downward
rate shock.
  At both
September 30, 2008 and December 31, 2007, the percentage changes from the base
forecasted 12-month net interest income are within internal policy guidelines
and shows that interest rate risk was not overly significant at September 30,
2008.
  TABLE
8
  NORTHERN
STATES FINANCIAL CORPORATION
  EFFECT OF
INTEREST SHOCKS ON NET INTEREST INCOME
  as of
September 30, 2008 and December 31, 2007
  ($000s)
  Immediate
      Change in Rates-2.00%
                            
                            
                            
                            -1.00%
                            
                            
                            
                            +1.00%
                            
                            
                            
                            +2.00%September
      30, 2008:Dollar
      Change from Base Forecast
                            
                            $
                            258
                            
                            
                            $
                            144
                            
                            
                            $
                            71
                            
                            
                            $
                            116Percent
      Change from Base Forecast
                            
                            
                            1.27
                            %
                            
                            
                            0.71
                            %
                            
                            
                            0.35
                            %
                            
                            
                            0.57
                            %December
      31, 2007:Dollar
      Change from Base Forecast
                            
                            $
                            (222
                            )
                            
                            $
                            (137
                            )
                            
                            $
                            334
                            
                            
                            $
                            418Percent
      Change from Base Forecast
                            
                            
                            -1.10
                            %
                            
                            
                            -0.68
                            %
                            
                            
                            1.66
                            %
                            
                            
                            2.08
                            %
  26
 Index
 NORTHERN STATES FINANCIAL
CORPORATION
  ITEM
4. CONTROLS AND PROCEDURES
  The
Company’s management has evaluated, with the participation of the Chairman of
the Board and President, and Vice President and Treasurer, the Company’s
disclosure controls and procedures (as such term is defined in Rule 13a – 15(e)
under the Securities Exchange Act of 1934) as of the end of the period covered
by this report.  Based on that evaluation, the Chairman of the Board
and President, and Vice President and Treasurer have concluded that these
controls and procedures were effective as of such date.  There were no
changes in internal control over financial reporting (as such term is defined in
Rule 13a – 15(f) under the Securities Exchange Act of 1934) that occurred during
the third quarter of 2008 that materially affected, or are reasonably likely to
materially affect, the Company’s internal control over financial
reporting.
  PART
II.OTHER INFORMATION
  ITEM
1.  LEGAL PROCEEDINGS
  From time
to time, due to the nature of its business, the Company and its subsidiaries are
often subject to various legal actions.  These legal actions, whether
pending or threatened, arise through the normal course of business and neither
the Company nor any of its subsidiaries are currently involved in any
proceedings that would, in management’s judgement, have a material adverse
effect on the Company’s business, results of operation, financial condition or
cash flows.
  ITEM
1A. RISK FACTORS
  There
have been no material changes to the risk factors relating to the Company from
those risk factors previously disclosed in the Company’s Annual Report on Form
10-K for its fiscal year ended December 31, 2007 in response to Item 1A. to Part
I of Form 10-K.
  ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND
USE OF PROCEEDS
  None
  ITEM
3.  DEFAULTS UPON SENIOR SECURITIES
  None
  ITEM
4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS
  None
  27
 Index
 NORTHERN STATES FINANCIAL
CORPORATION
  ITEM
5.  OTHER INFORMATION
  None
  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.
  28
 Index
 NORTHERN STATES FINANCIAL
CORPORATION
 FORM
10-Q
 September 30,
2008
  
  SIGNATURES
  
  Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report on Form 10-Q to be signed on its behalf by the
undersigned hereunto duly authorized, on this 5th day of November
2008.
   NORTHERN STATES FINANCIAL
CORPORATION (Registrant)
  
  
  Date:
      November
      5, 2008
                                        By:  /s/ Fred Abdula
                                          Fred
      Abdula
                                          Chairman of the
      Board of
                                          Directors and
      PresidentDate:
      November
      5, 2008
                                        By: /s/ Thomas M. Nemeth
                                          Thomas
      M. Nemeth
                                          Vice
      President and Treasurer
 29
 Index
  NORTHERN STATES FINANCIAL
CORPORATION
 FORM
10-Q
 September 30,
2008
  
  EXHIBIT
INDEX
   Exhibits
  
  Exhibit
3.1  Articles of Incorporation of the Company, as amended to date.
(Filed with Company’s annual report on Form 10-K for the year ended December 31,
1994 (Commission File 0-19300) and incorporated herein by
reference.)
  Exhibit
3.2  By-Laws of the Company, as amended and restated to date. (Filed
with Company’s quarterly report on Form 10-Q for the quarter ended March 31,
2004 (Commission File 0-19300) and incorporated herein by
reference.)
  Exhibit
4.1  Certain instruments defining the rights of holders of long-term
debt of the Company and certain of its subsidiaries, none of which authorize a
total amount of indebtedness in excess of 10% of the total assets of the Company
and its subsidiaries on a consolidated basis, have not been filed as
exhibits.  The Company hereby agrees to furnish a copy of any of these
agreements to the SEC upon request.
  Exhibit
31.1 Section 302  Certification of Chairman of the Board and
President.
  Exhibit
31.2 Section 302  Certification of Vice President and
Treasurer.
  Exhibit
32.1 Section 906  Certification.
  30