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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934

For the fiscal year ended December 31, 2013

Commission file number 0-12422

MAINSOURCE FINANCIAL GROUP, INC.
(Exact name of registrant as specified in its charter)

Indiana
(State or other jurisdiction
of incorporation or organization)
  35-1562245
(I.R.S. Employer
Identification No.)

2105 North State Road 3 Bypass
Greensburg, Indiana 47240

(Address of principal executive offices) (Zip code)

Registrant's telephone number, including area code:
(812) 663-6734

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
Common shares, no par value

 

Name of each exchange on which registered
The NASDAQ Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act:
None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o    No ý

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o    No ý

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 such 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 o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the previous 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý    No o

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

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.

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

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

The aggregate market value (not necessarily a reliable indication of the price at which more than a limited number of shares would trade) of the voting stock held by non-affiliates of the registrant was $273,856,945 as of June 30, 2013.

As of March 14, 2014, there were outstanding 20,424,224 common shares, without par value, of the registrant.

DOCUMENTS INCORPORATED BY REFERENCE

Documents
 
Part of Form 10-K
Into Which Incorporated
Definitive Proxy Statement for Annual
Meeting of Shareholders to be held
April 30, 2014
  Part III (Items 10 through 14)



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FORM 10-K

TABLE OF CONTENTS

PART I

  Page

Item 1

 

Business

 

3
Item 1A   Risk Factors   10
Item 1B   Unresolved Staff Comments   15
Item 2   Properties   15
Item 3   Legal Proceedings   15
Item 4   Mine Safety Disclosures   15

 

 

 

 

 

PART II

   

Item 5

 

Market For Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

16
Item 6   Selected Financial Data   18
Item 7   Management's Discussion and Analysis of Financial Condition and Results of Operations   19
Item 7A   Quantitative and Qualitative Disclosures About Market Risk   32
Item 8   Financial Statements and Supplementary Data   34
Item 9   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   77
Item 9A   Controls and Procedures   77
Item 9B   Other Information   77

 

 

 

 

 

PART III

   

Item 10

 

Directors, Executive Officers and Corporate Governance

 

See below
Item 11   Executive Compensation   See below
Item 12   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   See below
Item 13   Certain Relationships and Related Transactions and Director Independence   See below
Item 14   Principal Accounting Fees and Services   See below

 

 

 

 

 

PART IV

   

Item 15

 

Exhibits, Financial Statement Schedules

 

78

       Pursuant to General Instruction G, the information called for by Items 10-14 is omitted by MainSource Financial Group, Inc. since MainSource Financial Group, Inc. will file with the Commission a definitive proxy statement for its 2014 Annual Meeting of Shareholders pursuant to Regulation 14A not later than 120 days after the close of the fiscal year containing the information required by Items 10-14.

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PART I.

(Dollar amounts in thousands except per share data)

ITEM 1.   BUSINESS

General

       MainSource Financial Group, Inc. ("MainSource" or the "Company") is an Indiana corporation and bank holding company, within the meaning of the Bank Holding Company Act of 1956, as amended (the "BHC Act"), that has elected to become a financial holding company ("FHC"). The Company is based in Greensburg, Indiana. As of December 31, 2013, the Company operated one banking subsidiary: MainSource Bank ("the Bank"), an Indiana state chartered bank. Through its non-bank affiliates, the Company provides services incidental to the business of banking. Since its formation in 1982, the Company has acquired and established various institutions and financial services companies and may acquire additional financial institutions and financial services companies in the future. For further discussion of the business of the Company see Management's Discussion and Analysis in Part II, Item 7.

       As of December 31, 2013, the Company operated 74 branch banking offices in Indiana, Illinois, Ohio and Kentucky. As of December 31, 2013, the Company had consolidated assets of $2,859,864, consolidated deposits of $2,200,628 and shareholders' equity of $305,526.

       Through the Bank, the Company offers a broad range of financial services, including: accepting time and transaction deposits; making consumer, commercial, agribusiness and real estate mortgage loans; renting safe deposit facilities; providing personal and corporate trust services; and providing other corporate services such as letters of credit and repurchase agreements.

       The lending activities of the Bank are separated into primarily the categories of commercial, commercial real estate, residential, and consumer. Loans are originated by the lending officers of the Bank subject to limitations set forth in lending policies. The Board of Directors of the Bank monitors concentrations of credit, problem and past due loans and charge-offs of uncollectible loans and approves loan policy. The Bank maintains conservative loan policies and underwriting practices in order to address and manage loan risks. These policies and practices include granting loans on a sound and collectible basis, serving the legitimate needs of the community and the general market area while obtaining a balance between maximum yield and minimum risk, ensuring that primary and secondary sources of repayment are adequate in relation to the amount of the loan, developing and maintaining adequate diversification of the loan portfolio as a whole and of the loans within each category and developing and applying adequate collection policies.

       Commercial loans include secured and unsecured loans, including real estate loans, to individuals and companies and to governmental units predominantly within the market area of the Bank for a myriad of business purposes.

       Agricultural loans are generated in the Bank's markets. Most of the loans are real estate loans on farm properties. Loans are also made for agricultural production and such loans are generally reviewed annually.

       Residential real estate lending has been the largest component of the loan portfolio for many years. The Bank generates residential mortgages for its own portfolio. However, the Company elects to sell the majority of its fixed rate mortgages into the secondary market while maintaining the servicing of such loans. At December 31, 2013, the Company was servicing a $786 million residential real estate loan portfolio. By originating loans for sale in the secondary market, the Company can more fully satisfy customer demand for fixed rate residential mortgages and increase fee income, while reducing the risk of loss caused by rising interest rates.

       The principal source of revenues for the Company is interest and fees on loans, which accounted for 53.4% of total revenues in 2013, 55.0% in 2012 and 55.7% in 2011. While the Company's chief decision makers monitor the revenue streams of the various Company products and services, the identifiable segments are not material and operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company's financial service operations are considered by management to be aggregated in one reportable operating segment.

       The Company's investment securities portfolio is primarily comprised of state and municipal bonds; U. S. government sponsored entities' mortgage-backed securities and collateralized mortgage obligations; and corporate securities. The Company has classified its entire investment portfolio as available for sale, with fair value changes reported separately in shareholders' equity. Funds invested in the investment portfolio generally represent funds not immediately required to meet loan demand. Income related to the Company's investment portfolio accounted for 16.7% of total revenues in 2013, 16.2% in 2012 and 17.0% in 2011. As of December 31, 2013, the Company had not identified any securities as being "high risk" as defined by the FFIEC Supervisory Policy Statement on Securities Activities.

       The primary source of funds for the Bank is deposits generated in local market areas. To attract and retain stable depositors, the Bank markets various programs for demand, savings and time deposit accounts. These programs include interest and non-interest bearing demand and individual retirement accounts.

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       Currently, national retailing and manufacturing subsidiaries, brokerage and insurance firms and credit unions are fierce competitors within the financial services industry. Mergers between financial institutions within Indiana and neighboring states, which became permissible under the Interstate Banking and Branching Efficiency Act of 1994, have also added competitive pressure.

       The branches of the Bank are predominantly located in non-metropolitan areas and the Bank's business is centered in loans and deposits generated within markets considered largely rural in nature. In addition to competing vigorously with other banks, thrift institutions, credit unions and finance companies located within their service areas, we also compete, directly and indirectly, with all providers of financial services.

Employees

       As of December 31, 2013, the Company and its subsidiaries had 772 full-time equivalent employees to whom they provide a variety of benefits and with whom they enjoy excellent relations. None of our employees are subject to collective bargaining agreements.

Available Information

       We make available free of charge on or through our Internet web site, www.mainsourcebank.com, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K and all amendments to those reports filed or furnished pursuant to Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act") as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission ("SEC"). Such materials are also available free of charge on the SEC website, www.sec.gov. We have included our and the SEC's Internet website addresses throughout this Annual Report on Form 10-K as textual references only. The information contained on these websites is not incorporated into this Annual Report on Form 10-K.

Regulation and Supervision

       The Company is a financial holding company ("FHC") within the meaning of the Bank Holding Company Act of 1956, as amended. As a FHC, the Company is subject to regulation by the Federal Reserve Board ("FRB"). The Bank is an Indiana state chartered bank subject to supervision and regulation by the Federal Deposit Insurance Corporation ("FDIC") and the Indiana Department of Financial Institutions. The following is a discussion of material statutes and regulations affecting the Company and the Bank. The discussion is qualified in its entirety by reference to such statutes and regulations.

    Bank Holding Company Act of 1956, as amended

       Generally, the BHC Act governs the acquisition and control of banks and nonbanking companies by bank holding companies. A bank holding company is subject to regulation by and is required to register with the FRB under the BHC Act. The BHC Act requires a bank holding company to file an annual report of its operations and such additional information as the FRB may require. The FRB has issued regulations under the BHC Act requiring a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. It is the policy of the FRB that, pursuant to this requirement, a bank holding company should stand ready to use its resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity.

       The acquisition of 5% or more of the voting shares of any bank or bank holding company generally requires the prior approval of the FRB and is subject to applicable federal and state law, including the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 ("Riegle-Neal") for interstate transactions. The FRB evaluates acquisition applications based on, among other things, competitive factors, supervisory factors, adequacy of financial and managerial resources, and banking and community needs considerations.

       The BHC Act also prohibits, with certain exceptions, a bank holding company from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any "nonbanking" company unless the nonbanking activities are found by the FRB to be "so closely related to banking...as to be a proper incident thereto." Under current regulations of the FRB, a bank holding company and its nonbank subsidiaries are permitted, among other activities, to engage in such banking-related business ventures as consumer finance, equipment leasing, data processing, mortgage banking, financial and investment advice, and securities brokerage services. The BHC Act does not place territorial restrictions on the activities of a bank holding company or its nonbank subsidiaries.

       Federal law prohibits acquisition of "control" of a bank or bank holding company without prior notice to certain federal bank regulators. "Control" is defined in certain cases as the acquisition of as little as 10% of the outstanding shares of any class of voting stock. Furthermore, under certain circumstances, a bank holding company may not be able to purchase its own stock, where the gross consideration will equal 10% or more of the company's net worth, without obtaining approval of the FRB. Under the Federal Reserve Act, banks and their affiliates are subject to certain requirements and restrictions when dealing with each other (affiliate transactions include transactions between a bank and its bank holding company).

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    Gramm-Leach-Bliley Financial Modernization Act of 1999

       The Gramm-Leach-Bliley Financial Modernization Act of 1999 (the "Modernization Act") was enacted on November 12, 1999. The Modernization Act, which amended the BHC Act, provides the following:

    it allows bank holding companies that qualify as "financial holding companies" to engage in a broad range of financial and related activities;

    it allows insurers and other financial services companies to acquire banks;

    it removes various restrictions that applied to bank holding company ownership of securities firms and mutual fund advisory companies; and

    it establishes the overall regulatory structure applicable to bank holding companies that also engage in insurance and securities operations.

       The Company initially qualified as a financial holding company in December, 2004. Thus the Company is authorized to operate as a financial holding company and is eligible to engage in, or acquire companies engaged in, the broader range of activities that are permitted by the Modernization Act. These activities include those that are determined to be "financial in nature," including insurance underwriting, securities underwriting and dealing, and making merchant banking investments in commercial and financial companies. If a banking subsidiary ceases to be "well capitalized" or "well managed" under applicable regulatory standards, the FRB may, among other things, place limitations on our ability to conduct these broader financial activities or, if the deficiencies persist, require us to divest the banking subsidiary. In addition, if a banking subsidiary receives a rating of less than satisfactory under the Community Reinvestment Act of 1977 ("CRA"), we would be prohibited from engaging in any additional activities other than those permissible for bank holding companies that are not financial holding companies.

    Bank Secrecy Act and USA Patriot Act

       In 1970, Congress enacted the Currency and Foreign Transactions Reporting Act, commonly known as the Bank Secrecy Act (the "BSA"). The BSA requires financial institutions to maintain records of certain customers and currency transactions and to report certain domestic and foreign currency transactions, which may have a high degree of usefulness in criminal, tax, or regulatory investigations or proceedings. Under this law, financial institutions are required to develop a BSA compliance program.

       In 2001, the President signed into law comprehensive anti-terrorism legislation known as the USA Patriot Act. Title III of the USA Patriot Act requires financial institutions, including the Company and the Bank, to help prevent and detect international money laundering and the financing of terrorism and prosecute those involved in such activities. The Department of the Treasury has adopted additional requirements to further implement Title III.

       Under these regulations, a mechanism has been established for law enforcement officials to communicate names of suspected terrorists and money launderers to financial institutions to enable financial institutions to promptly locate accounts and transactions involving those suspects. Financial institutions receiving names of suspects must search their account and transaction records for potential matches and report positive results to the U.S. Department of the Treasury Financial Crimes Enforcement Network ("FinCEN"). Each financial institution must designate a point of contact to receive information requests. These regulations outline how financial institutions can share information concerning suspected terrorist and money laundering activity with other financial institutions under the protection of a statutory safe harbor if each financial institution notifies FinCEN of its intent to share information. The Department of the Treasury has also adopted regulations intended to prevent money laundering and terrorist financing through correspondent accounts maintained by U.S. financial institutions on behalf of foreign banks. Financial institutions are required to take reasonable steps to ensure that they are not providing banking services directly or indirectly to foreign shell banks. In addition, banks must have procedures in place to verify the identity of the persons with whom they deal.

    FDIC Improvement Act of 1991

       The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") requires, among other things, federal bank regulatory authorities to take "prompt corrective action" with respect to banks which do not meet minimum capital requirements. For these purposes, FDICIA establishes five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. The FDIC has adopted regulations to implement the prompt corrective action provisions of FDICIA.

       "Undercapitalized" banks are subject to growth limitations and are required to submit a capital restoration plan. A bank's compliance with such plan is required to be guaranteed by the bank's parent holding company. If an "undercapitalized" bank fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. "Significantly undercapitalized" banks are subject to one or more restrictions, including an order by the FDIC to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cease receipt of deposits from correspondent banks, and restrictions on compensation of

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executive officers. "Critically undercapitalized" institutions may not, beginning 60 days after becoming "critically undercapitalized," make any payment of principal or interest on certain subordinated debt or extend credit for a highly leveraged transaction or enter into any transaction outside the ordinary course of business. In addition, "critically undercapitalized" institutions are subject to appointment of a receiver or conservator.

       Currently, a "well capitalized" institution is one that has a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6%, a leverage ratio of at least 5% and is not subject to regulatory direction to maintain a specific level for any capital measure. An "adequately capitalized" institution is one that has ratios greater than 8%, 4% and 4%. An institution is "undercapitalized" if its respective ratios are less than 8%, 4% and 4%. "Significantly undercapitalized" institutions have ratios of less than 6%, 3% and 3%. An institution is deemed to be "critically undercapitalized" if it has a ratio of tangible equity to total assets that is 2% or less.

    The Sarbanes-Oxley Act

       The Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act") represents a comprehensive revision of laws affecting corporate governance, accounting obligations and corporate reporting. Among other requirements, the Sarbanes-Oxley Act established: (i) requirements for audit committees of public companies, including independence and expertise standards; (ii) additional responsibilities regarding financial statements for the chief executive officers and chief financial officers of reporting companies; (iii) standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for reporting companies regarding various matters relating to corporate governance, and (v) new and increased civil and criminal penalties for violation of the securities laws.

    Deposit Insurance Fund

       The deposits of the Bank are insured to the maximum extent permitted by law by the Deposit Insurance Fund ("DIF") of the FDIC, which was created in 2006 as the result of the merger of the Bank Insurance Fund and the Savings Association Insurance Fund in accordance with the Federal Deposit Insurance Reform Act of 2005 (the "FDI Act"). The FDIC maintains the DIF by assessing depository institutions an insurance premium. Pursuant to the Dodd-Frank Act, the FDIC is required to set a DIF reserve ratio of 1.35% of estimated insured deposits and is required to achieve this ratio by September 30, 2020.

       Under the FDIC's risk-based assessment system, insured institutions are required to pay deposit insurance premiums based on the risk that each institution poses to the DIF. An institution's risk to the DIF is measured by its regulatory capital levels, supervisory evaluations, and certain other factors. An institution's assessment rate depends upon the risk category to which it is assigned. As noted above, pursuant to the Dodd-Frank Act, the FDIC will calculate an institution's assessment level based on its total average consolidated assets during the assessment period less average tangible equity (i.e., Tier 1 capital) as opposed to an institution's deposit level which was the previous basis for calculating insurance assessments. Pursuant to the Dodd-Frank Act, institutions will be placed into one of four risk categories for purposes of determining the institution's actual assessment rate. The FDIC will determine the risk category based on the institution's capital position (well capitalized, adequately capitalized, or undercapitalized) and supervisory condition (based on exam reports and related information provided by the institution's primary federal regulator).

    Dividends

       The Company is a legal entity separate and distinct from the Bank. There are various legal limitations on the extent to which the Bank can supply funds to the Company. The principal source of the Company's funds consists of dividends from the Bank. State and Federal law restricts the amount of dividends that may be paid by banks. The specific limits depend on a number of factors, including the bank's type of charter, recent earnings, recent dividends, level of capital and regulatory status. The regulators are authorized, and under certain circumstances are required, to determine that the payment of dividends or other distributions by a bank would be an unsafe or unsound practice and to prohibit that payment. For example, the FDI Act generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be undercapitalized.

       The Dodd-Frank Act and its accompanying regulations also limit a depository institution's ability to make capital distributions if it does not hold a 2.5% capital buffer above the required minimum risk-based capital ratios. Regulators also review and limit proposed dividend payments as part of the supervisory process and review of an institution's capital planning. In addition to dividend limitations, the Bank is subject to certain restrictions on extensions of credit to the Company, on investments in the stock or other securities of the Company and in taking such stock or securities as collateral for loans.

    Community Reinvestment Act

       The Community Reinvestment Act requires that the federal banking regulators evaluate the records of a financial institution in meeting the credit needs of its local community, including low and moderate income neighborhoods. These factors are also

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considered in evaluating mergers, acquisitions, and applications to open a branch or facility. Failure to adequately meet these criteria could result in the imposition of additional requirements and limitations on the Bank.

    Capital Requirements

       As discussed above, the Company and the Bank must meet certain minimum capital requirements mandated by each of their state or federal regulators. These regulatory agencies require BHCs and banks to maintain certain minimum ratios of primary capital to total assets and total capital to total assets. The FRB requires BHCs to maintain a minimum Tier 1 leverage ratio of 3% capital to total assets; however, for all but the most highly rated institutions which do not anticipate significant growth, the minimum Tier 1 leverage ratio is 3% plus an additional cushion of 100 to 200 basis points. As of December 31, 2013, the Company's leverage ratio of capital to total assets was 10.1%. The FRB and FDIC each have approved the imposition of "risk-adjusted" capital ratios on BHCs and financial institutions. The Company's Tier 1 Capital to Risk-Weighted Assets Ratio was 15.4% and its Total Capital to Risk-Weighted Assets Ratio was 16.7% at December 31, 2013. The Bank had capital to asset ratios and risk- adjusted capital ratios at December 31, 2013, in excess of the applicable minimum regulatory requirements.

    The Dodd-Frank Wall Street Reform and Consumer Protection Act

       On July 21, 2010, President Obama signed into law the sweeping financial regulatory reform act entitled the "Dodd-Frank Wall Street Reform and Consumer Protection Act" (Dodd-Frank Act). This significant law affects the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. Various federal agencies are given significant discretion in drafting and implementing a broad range of new rules and regulations, and consequently, while many new rules and regulation have been adopted, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.

       Certain provisions of Dodd-Frank are now effective and have been fully implemented, including the revisions in the deposit insurance assessment base for FDIC insurance and the permanent increase in coverage to $250,000; the permissibility of paying interest on business checking accounts; the removal of barriers to interstate branching and required disclosure and shareholder advisory votes on executive compensation. Action in 2013 to implement the final Dodd-Frank provisions included (i) final new capital rules, (ii) a final rule to implement the so called "Volcker rule" restrictions on certain proprietary trading and investment activities and (iii) final rules and increased enforcement action by the Consumer Finance Protection Bureau ("CFPB").

       Key provisions of the Dodd-Frank Act are as follows:

    eliminated the federal prohibitions on paying interest on demand deposits, thus allowing businesses to have interest bearing checking accounts.

    broadened the base for Federal Deposit Insurance Corporation insurance assessments.

    required publicly traded companies to give stockholders a nonbinding vote on executive compensation and so-called "golden parachute" payments.

    broadened the scope of derivative instruments, and subjected covered institutions to increased regulation of its derivative business, including margin requirements, record keeping and reporting requirements, and heightened supervision.

    created a new Consumer Financial Protection Bureau with broad powers to supervise and enforce consumer protection laws. Banks and savings institutions with $10 billion or less in assets will continue to be examined for compliance with consumer laws by their primary bank regulators. The CFPB, along with the Department of Justice and bank regulatory authorities also seek to enforce discriminatory lending laws. In such actions, the CFPB and others have used a disparate impact analysis, which measures discriminatory results without regard to intent.

    debit card and interchange fees must be reasonable and proportional to the issuer's cost for processing the transaction. The Federal Reserve Board has approved a debit card interchange regulation which caps an issuer's base fee at $0.21 per transaction plus an additional fee computed at five basis-points of the transaction value. These standards apply to issuers that, together with their affiliates, have assets of $10 billion or more. The Company's assets are under $10 billion and therefore it is not directly impacted by these provisions.

    S.A.F.E. Act Requirements

       Regulations issued under the Secure and Fair Enforcement for Mortgage Licensing Act of 2008 (the "S.A.F.E. Act") require residential mortgage loan originators who are employees of institutions regulated by the foregoing agencies, including national banks, to meet the registration requirements of the S.A.F.E. Act. The S.A.F.E. Act requires residential mortgage loan originators who are employees of regulated financial institutions to be registered with the Nationwide Mortgage Licensing System and Registry, a database created by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators to

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support the licensing of mortgage loan originators by the states. Employees of regulated financial institutions are generally prohibited from originating residential mortgage loans unless they are registered.

    Basel III

       In December 2010, the Basel Committee released its final framework for strengthening international capital and liquidity regulation, officially identified by the Basel Committee as "Basel III". The Basel III standards operate in conjunction with portions of standards previously released by the Basel Committee and commonly known as "Basel II" and "Basel 2.5." On June 7, 2012, the Federal Reserve Board, FDIC, and the Office of the Comptroller of the Currency requested comment on these proposed rules that, taken together, would implement the Basel regulatory capital reforms through what are referred to herein as the "Basel III capital framework."

       On July 2, 2013, the Federal Reserve adopted a final rule for the Basel III capital framework and, on July 9, 2013, the FDIC adopted the same provisions in the form of an "interim" final rule. The rule will apply to all national and state banks and savings associations and most bank holding companies and savings and loan holding companies, which are collectively referred to herein as "covered" banking organizations. The requirements in the rule begin to phase in on January 1, 2015 for covered banking organizations (including the Company). The requirements in the rule will be fully phased in by January 1, 2019. Although many of the rules contained in these final regulations are applicable only to large, internationally active banks, some of them will apply on a phased in basis to all banking organizations, including the Company and the Bank.

       The following are among the new requirements that will be phased in beginning January 1, 2015:

    an increase in the minimum Tier 1 capital ratio from 4.00% to 6.00% of risk-weighted assets.

    a new category and a required 4.50% of risk-weighted assets ratio is established for "common equity Tier 1" as a subset of Tier 1 capital limited to common equity.

    a minimum non-risk-based leverage ratio is set at 4.00% eliminating a 3.00% exception for higher rated banks.

    changes in the permitted composition of Tier 1 capital to exclude trust preferred securities, mortgage servicing rights and certain deferred tax assets and include unrealized gains and losses on available for sale debt and equity securities.

    a new additional capital conservation buffer of 2.5% of risk weighted assets over each of the required capital ratios that will be phased in from 2016 to 2019 must be met to avoid limitations in the ability of the Bank to pay dividends, repurchase shares or pay discretionary bonuses.

    the risk-weights of certain assets for purposes of calculating the risk-based capital ratios are changed for high volatility commercial real estate acquisition, development and construction loans, certain past due non-residential mortgage loans and certain mortgage-backed and other securities exposures.

    an additional "countercyclical capital buffer" is required for larger and more complex institutions.

    Volcker Rule

       On December 10, 2013, the Federal Reserve, the Office of the Comptroller of the Currency, the FDIC, the CFTC and the SEC issued final rules to implement the Volcker Rule contained in section 619 of the Dodd-Frank Act, generally to become effective on July 21, 2015. The Volcker Rule prohibits an insured depository institution and its affiliates from: (i) engaging in "proprietary trading" and (ii) investing in or sponsoring certain types of funds ("covered funds") subject to certain limited exceptions. The rule also effectively prohibits short-term trading strategies by any U.S. banking entity if those strategies involve instruments other than those specifically permitted for trading and prohibits the use of some hedging strategies.

       Under these rules and subject to certain exceptions, banking entities, including the Company and the Bank, will be restricted from engaging in activities that are considered proprietary trading and from sponsoring or investing in certain entities, including hedge or private equity funds that are considered "covered funds." These rules will become effective on April 1, 2014. Certain collateralized debt obligations ("CDO") securities backed by trust preferred securities were initially defined as covered funds subject to the investment prohibitions of the final rule. Action taken by the Federal Reserve in January 2014 exempted many such securities to address the concern that community banks holding such CDO securities may have been required to recognize losses on those securities.

    Office of Foreign Assets Control Regulation

       The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others which are administered by the U.S. Treasury Department Office of Foreign Assets Control. Failure to comply with these sanctions could have serious legal and reputational consequences, including causing applicable bank regulatory authorities not to

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approve merger or acquisition transactions when regulatory approval is required or to prohibit such transactions even if approval is not required.

    Incentive Compensation

       The Dodd-Frank Act requires the federal bank regulatory agencies and the SEC to establish joint regulations or guidelines prohibiting incentive-based payment arrangements at specified regulated entities having at least $1 billion in total assets that encourage inappropriate risks by providing an executive officer, employee, director or principal stockholder with excessive compensation, fees, or benefits that could lead to material financial loss to the entity. In addition, these regulators must establish regulations or guidelines requiring enhanced disclosure of incentive-based compensation arrangements to regulators. The agencies proposed such regulations in April 2011, but these regulations have not yet been finalized.

       In June 2010, the FRB and the FDIC issued comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization's incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization's ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization's board of directors. These three principles are incorporated into the proposed joint compensation regulations under The Dodd-Frank Act, discussed above. The FRB will review, as part of its regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Company, that are not "large, complex banking organizations." These reviews will be tailored to each organization based on the scope and complexity of the organization's activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization's supervisory ratings, which can affect the organization's ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization's safety and soundness and the organization is not taking prompt and effective measures to correct the deficiency.

    Future Legislation

       In addition to the specific legislation described above, various additional legislation is currently being considered by Congress. This legislation may change banking statutes and the Company's operating environment in substantial and unpredictable ways and may increase reporting requirements and governance. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities, or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. The Company cannot predict whether any potential legislation will be enacted and, if enacted, the effect that it, or any implementing regulations, would have on its business, results of operations, or financial condition.

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ITEM 1A.    RISK FACTORS

       In addition to the other information contained in this report, the following risks may affect us. If any of these risks actually occur, our business, financial condition or results of operations may suffer. As a result, the price of our common shares could decline.

Risks Related to Our Business.

Like most banking organizations, a significant portion of our assets consists of loans, which if not repaid could result in losses to the Company.

       As a lender, we are exposed to the risk that our customers will be unable to repay their loans according to their terms and that the collateral securing the payment of their loans (if any) may not be sufficient to assure repayment. Credit losses could have a material adverse effect on our operating results.

       As of December 31, 2013, our total loan portfolio was approximately $1,672 million or 58% of our total assets. Three major components of the loan portfolio are loans principally secured by real estate, approximately $1,415 million or 85% of total loans; other commercial loans, approximately $211 million or 12% of total loans; and consumer loans, approximately $46 million or 3% of total loans. Our credit risk with respect to our consumer installment loan portfolio and commercial loan portfolio relates principally to the general creditworthiness of individuals and businesses within our local market area. Our credit risk with respect to our residential and commercial real estate mortgage and construction loan portfolio relates principally to the general creditworthiness of individuals and businesses and the value of real estate serving as security for the repayment of the loans. A related risk in connection with loans secured by commercial real estate is the effect of unknown or unexpected environmental contamination, which could make the real estate effectively unmarketable or otherwise significantly reduce its value as security. Continued or worsening declines in the economy could cause additional credit issues, particularly within our residential and commercial real estate mortgage and construction loan portfolio.

Our allowance for loan losses may not be sufficient to cover actual loan losses, which could adversely affect our earnings.

       We maintain an allowance for loan losses at a level estimated by management to be sufficient to cover probable incurred loan losses in our loan portfolio. Loan losses will likely occur in the future and may occur at a rate greater than we have experienced to date. In determining the size of the allowance, our management makes various assumptions and judgments about the collectability of our loan portfolio, including the diversification by industry of our commercial loan portfolio, the effect of changes in the local real estate markets on collateral values, the results of recent regulatory examinations, the effects on the loan portfolio of current economic indicators and their probable impact on borrowers, the amount of charge-offs for the period, the amount of nonperforming loans and related collateral security, and the evaluation of our loan portfolio by an external loan review. If our assumptions and judgments prove to be incorrect, our current allowance may not be sufficient and adjustments may be necessary to allow for different economic conditions or adverse developments in our loan portfolio. Additionally, continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside the Company's control, may require an increase in the allowance for loan losses. Federal and state regulators also periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in our allowance for loan losses or loan charge-offs could have an adverse effect on our operating results and financial condition. There can be no assurance that our monitoring procedures and policies will reduce certain lending risks or that our allowance for loan losses will be adequate to cover actual losses.

If we foreclose on collateral property, we may be subject to the increased costs associated with ownership of real property, resulting in reduced revenues and earnings.

       We may have to foreclose on collateral property to protect our investment and may thereafter own and operate such property, in which case we will be exposed to the risks inherent in the ownership of real estate. The amount that we, as a mortgagee, may realize after a default is dependent upon factors outside of our control, including, but not limited to: (i) general or local economic conditions; (ii) neighborhood values; (iii) interest rates; (iv) real estate tax rates; (v) operating expenses of the mortgaged properties; (vi) environmental remediation liabilities; (vii) ability to obtain and maintain adequate occupancy of the properties; (viii) zoning laws; (ix) governmental rules, regulations and fiscal policies; and (x) acts of God. Certain expenditures associated with the ownership of real estate, principally real estate taxes, insurance, and maintenance costs, may adversely affect the income from the real estate. Therefore, the cost of operating real property may exceed the income earned from such property, and we may have to advance funds in order to protect our investment, or we may be required to dispose of the real property at a loss. The foregoing expenditures and costs could adversely affect our ability to generate revenues, resulting in reduced levels of profitability.

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Significant interest rate volatility could reduce our profitability.

       The interest rate risk inherent in our lending, investing, and deposit taking activities is a significant market risk to us and our business. We derive our income mainly from the difference or "spread" between the interest earned on loans, securities and other interest earning assets, and interest paid on deposits, borrowings and other interest bearing liabilities. In general, the wider the spread, the more net interest income we earn. When market rates of interest change, the interest we receive on our assets and the interest we pay on our liabilities will fluctuate. This can cause decreases in our spread and can greatly affect our income. In addition, interest rate fluctuations can affect how much money we may be able to lend. Changes in interest rates may also affect the level of voluntary prepayments on our loans and the level of financing or refinancing by customers. There can be no assurance that we will be successful in minimizing the adverse effects of changes in interest rates.

New mortgage regulations may adversely impact our business.

       Revisions made pursuant to Dodd-Frank to Regulation Z, which implements the Truth in Lending Act (TILA), effective in January 2014, apply to all consumer mortgages (except home equity lines of credit, timeshare plans, reverse mortgages, or temporary loans), and mandate specific underwriting criteria and "ability to repay" requirements for home loans. This may impact our offering and underwriting of single family residential loans in our residential mortgage lending operation and could have a resulting unknown effect on potential delinquencies. In addition, the relatively uniform requirements may make it difficult for regional and community banks to compete against the larger national banks for single family residential loan originations.

We may be required to pay significantly higher Federal Deposit Insurance Corporation (FDIC) premiums in the future.

       Insured institution failures during the past several years have significantly increased FDIC loss provisions, resulting in a decline in the designated reserve ratio to historical lows. In addition the Dodd-Frank Act permanently implemented FDIC insurance coverage for all deposit accounts up to $250,000 and revised the insurance premium assessment base from all domestic deposits to the average of total assets less tangible equity. The minimum reserve ratio of the deposit insurance fund has been increased from 1.15% to 1.35%, with the increase to be covered by assessments on insured institutions with assets over $10 billion until the new reserve ratio is reached.

       We are generally unable to control the amount of premiums that we are required to pay for FDIC insurance. If there are additional bank or financial institution failures, we may be required to pay even higher FDIC premiums than the recently increased levels. Additionally, the FDIC may make material changes to the calculation of the prepaid assessment from the current proposal. Any future changes in the calculation or assessment of FDIC insurance premiums may have a material adverse effect on our results of operations, financial condition and our ability to continue to pay dividends on our common shares at the current rate or at all.

Future growth or operating results may require the Company to raise additional capital but that capital may not be available or it may be dilutive.

       We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. To the extent our future operating results erode capital or we elect to expand through loan growth or acquisition we may be required to raise capital. Our ability to raise capital will depend on conditions in the capital markets, which are outside of our control, and on our financial performance. Accordingly, we cannot be assured of our ability to raise capital if needed or on favorable terms. If we cannot raise additional capital when needed, we will be subject to increased regulatory supervision and the imposition of restrictions on our growth and business. These could negatively impact our ability to operate or further expand our operations through acquisitions or the establishment of additional branches and may result in increases in operating expenses and reductions in revenues that could have a material adverse effect on our financial condition and results of operations.

We rely heavily on our management and other key personnel, and the loss of any of them may adversely affect our operations.

       We are and will continue to be dependent upon the services of our management team. The loss of any of our senior managers could have an adverse effect on our growth and performance because of their skills, knowledge of the markets in which we operate and years of industry experience and the difficulty of promptly finding qualified replacement personnel. The loss of key personnel in a particular market could have an adverse effect on our performance in that market because it may be difficult to find qualified replacement personnel who are already located in or would be willing to relocate to a non-metropolitan market. Additionally, recent regulations issued by banking regulators regarding executive compensation may impact our ability to compensate executives and, as a result, to attract and retain qualified personnel.

The geographic concentration of our markets makes our business highly susceptible to local economic conditions.

       Unlike larger banking organizations that are more geographically diversified, our operations are currently concentrated in 30 counties in Indiana, three counties in Illinois, two counties in Ohio, and three counties in Kentucky. As a result of this geographic

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concentration in four fairly contiguous markets, our financial results depend largely upon economic conditions in these market areas. A deterioration in economic conditions in one or all of these markets could result in one or more of the following:

    an increase in loan delinquencies;

    an increase in problem assets and foreclosures;

    a decrease in the demand for our products and services; or

    a decrease in the value of collateral for loans, especially real estate, in turn reducing customers' borrowing power, the value of assets associated with problem loans and collateral coverage.

If we do not adjust to rapid changes in the financial services industry, our financial performance may suffer.

       We face substantial competition for deposit, credit and trust relationships, as well as other sources of funding in the communities we serve. Competing providers include other banks, thrifts and trust companies, insurance companies, mortgage banking operations, credit unions, finance companies, money market funds and other financial and nonfinancial companies which may offer products functionally equivalent to those offered by the Bank. Competing providers may have greater financial resources than we do and offer services within and outside the market areas we serve. In addition to this challenge of attracting and retaining customers for traditional banking services, our competitors now include securities dealers, brokers, mortgage bankers, investment advisors and finance and insurance companies who seek to offer one-stop financial services to their customers that may include services that banks have not been able or allowed to offer to their customers in the past. The increasingly competitive environment is primarily a result of changes in regulation, changes in technology and product delivery systems and the accelerating pace of consolidation among financial service providers. If we are unable to adjust both to increased competition for traditional banking services and changing customer needs and preferences, it could adversely affect our financial performance and your investment in our common stock.

Acquisitions entail risks which could negatively affect our operations.

       Acquisitions involve numerous risks, including:

    exposure to asset quality problems of the acquired institution;

    maintaining adequate regulatory capital;

    diversion of management's attention from other business concerns;

    risks and expenses of entering new geographic markets;

    potential significant loss of depositors or loan customers from the acquired institution; or

    exposure to undisclosed or unknown liabilities of an acquired institution.

       Any of these acquisition risks could result in unexpected losses or expenses and thereby reduce the expected benefits of the acquisition.

Unanticipated costs related to our acquisitions could reduce our future earnings per share.

       We believe we have reasonably estimated the likely costs of integrating the operations of the banks we acquire into the Company and the incremental costs of operating such banks as a part of the MainSource family. However, it is possible that unexpected transaction costs such as taxes, fees or professional expenses or unexpected future operating expenses, such as increased personnel costs or increased taxes, as well as other types of unanticipated adverse developments, could have a material adverse effect on the results of operations and financial condition of MainSource. If unexpected costs are incurred, acquisitions could have a dilutive effect on our earnings per share. Current accounting guidance requires expensing of acquisition costs. In prior years, these costs could be capitalized. In other words, if we incur such unexpected costs and expenses as a result of our acquisitions, we believe that the earnings per share of our common stock could be less than they would have been if those acquisitions had not been completed.

We may be unable to successfully integrate the operations of the banks we have acquired and may acquire in the future and retain employees of such banks.

       Our acquisition strategy involves the integration of the banks we have acquired and may acquire in the future as MainSource subsidiary banks. The difficulties of integrating the operations of such banks with MainSource and its other subsidiary banks include:

    coordinating geographically separated organizations;

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    integrating personnel with diverse business backgrounds;

    combining different corporate cultures; or

    retaining key employees.

       The process of integrating operations could cause an interruption of, or loss of momentum in, the activities of one or more of the Company, our subsidiary banks and the banks we have acquired and may acquire in the future and the loss of key personnel. The integration of such banks as MainSource subsidiary banks requires the experience and expertise of certain key employees of such banks who we expect to retain. We cannot be sure, however, that we will be successful in retaining these employees for the time period necessary to successfully integrate such banks' operations as subsidiary banks of MainSource. The diversion of management's attention and any delays or difficulties encountered in connection with the mergers, along with the integration of the banks as MainSource subsidiary banks, could have an adverse effect on our business and results of operation.

Risks Relating to the Banking Industry

Changes in governmental regulation and legislation could limit our future performance and growth.

       We are subject to extensive state and federal regulation, supervision and legislation that governs almost all aspects of our operations, as well as any acquisitions we may propose to make. Any change in applicable federal or state laws or regulations could have a substantial impact on us, our subsidiary banks and our operations. While we cannot predict what effect any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, these changes could reduce the value of your investment.

The implementation of final rules under the many provisions of Dodd-Frank Act could adversely affect us.

       Regulation of the financial services industry is undergoing major changes from the enactment and ongoing implementation of Dodd-Frank. Certain provisions of Dodd-Frank are effective and have been fully implemented, including the revisions in the deposit insurance assessment base for FDIC insurance and the permanent increase in FDIC coverage to $250,000; the permissibility of paying interest on business checking accounts; the removal of remaining barriers to interstate branching and required disclosure and shareholder advisory votes on executive compensation. Other recent actions to implement the final Dodd-Frank provisions include (i) final new capital rules, (ii) a final rule to implement the "Volcker Rule" restrictions on certain proprietary trading and investment activities and (iii) the promulgation of final rules and increased enforcement action by the CFPB. The full implementation of certain final rules is delayed or phased in over several years; therefore, as yet we cannot definitively assess what may be the short or longer term specific or aggregate effect of the full implementation of Dodd-Frank on us.

Changes in regulation or oversight may have a material adverse impact on our operations.

       We are subject to extensive regulation, supervision and examination by the Indiana Department of Financial Institutions, the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission and other regulatory bodies. Such regulation and supervision governs the activities in which we may engage. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, investigations and limitations related to our securities, the classification of our assets and determination of the level of our allowance for loan losses. In light of the current conditions in the U.S. financial markets and economy, Congress and regulators have increased their focus on the regulation of the financial services industry. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory action, may have a material adverse impact on our business, financial condition or results of operations.

Difficult conditions in the capital markets and the economy generally have affected and may continue to materially adversely affect our business and results of operations.

       From 2007 through 2009, the U.S. economy was in recession. Business activity across a wide range of industries and regions in the U.S. was greatly reduced. Although economic conditions have begun to improve, certain sectors, such as real estate, remain weak and unemployment remains high. Local governments and many businesses are still in serious difficulty due to lower consumer spending and the lack of liquidity in the credit markets. The Company's financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, as well as demand for loans and other products and services that the Company offers, is highly dependent upon the business environment in the markets where the Company operates and in the United States as a whole. A favorable business environment is generally characterized by, among other factors, economic growth, efficient capital markets, low inflation, low unemployment, high business and investor confidence, and strong business earnings. Unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the

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cost of credit and capital; increases in inflation or interest rates; high unemployment, natural disasters, or a combination of these or other factors.

       During 2012 and 2013, the business environment continued to be adverse for many households and businesses in the United States and worldwide. While economic conditions in the United States and worldwide have begun to improve, there can be no assurance that this improvement will continue. Such conditions have affected, and could continue to adversely affect, the credit quality of the Company's loans, results of operations and financial condition.

Changes in consumer use of banks and changes in consumer spending and savings habits could adversely affect our financial results.

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

Our earnings could be adversely impacted by incidences of fraud and compliance failure.

       Financial institutions are inherently exposed to fraud risk. A fraud can be perpetrated by a customer of MainSource, an employee, a vendor, or members of the general public. We are most subject to fraud and compliance risk in connection with the origination of loans, ACH transactions, ATM transactions and checking transactions. Our largest fraud risk, associated with the origination of loans, includes the intentional misstatement of information in property appraisals or other underwriting documentation provided to us by third parties. Compliance risk is the risk that loans are not originated in compliance with applicable laws and regulations and our standards. There can be no assurance that we can prevent or detect acts of fraud or violation of law or our compliance standards by the third parties that we deal with. Repeated incidences of fraud or compliance failures would adversely impact the performance of our loan portfolio.

Risks Related to the Company's Stock

We may not be able to pay dividends in the future in accordance with past practice.

       The Company has traditionally paid a quarterly dividend to common stockholders. The Company is a separate legal entity from the Bank and receives substantially all of its revenue and cash flow from dividends paid by the Bank to the Company. Indiana state law and agreements between the Bank and its federal and state regulators may limit the amount of dividends that the Bank may pay to the Company. In the event that the Bank is unable to pay dividends to the Company for an extended period of time, the Company may not be able to service its debt obligations or pay dividends on its common stock. Additionally, any payment of dividends in the future will depend, in large part, on the Bank's earnings, capital requirements, financial condition and other factors considered relevant by the Company's Board of Directors. Starting in the second quarter of 2009 and continuing to the second quarter of 2012, the Company reduced the amount of cash dividends paid. This reduction was made to preserve capital levels at the Company. Beginning in the third quarter of 2012, the Company raised the dividend to $.03/share, and in the first quarter of 2013 it raised the dividend to $.06/share. In the third quarter of 2013, the Company raised the dividend to $.08/share.

The price of the Company's common stock may be volatile, which may result in losses for investors.

       General market price declines or market volatility in the future could adversely affect the price of the Company's common stock. In addition, the following factors may cause the market price for shares of the Company's common stock to fluctuate:

    announcements of developments related to the Company's business;

    fluctuations in the Company's results of operations;

    sales or purchases of substantial amounts of the Company's securities in the marketplace;

    general conditions in the Company's banking niche or the worldwide economy;

    a shortfall or excess in revenues or earnings compared to securities analysts' expectations;

    changes in analysts' recommendations or projections; and

    the Company's announcement of new acquisitions or other projects.

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The Company's charter documents and federal regulations may inhibit a takeover, prevent a transaction that may favor or otherwise limit the Company's growth opportunities, which could cause the market price of the Company's common stock to decline.

       Certain provisions of the Company's charter documents and federal regulations could have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of the Company. In addition, the Company must obtain approval from regulatory authorities before acquiring control of any other company.

ITEM 1B.    UNRESOLVED STAFF COMMENTS.

       None.

ITEM 2.    PROPERTIES

       As of December 31, 2013, the Company leased an office building located in Greensburg, Indiana, from one of its subsidiaries for use as its corporate headquarters. The Company's subsidiaries own, or lease, all of the facilities from which they conduct business. All leases are comparable to other leases in the respective market areas and do not contain provisions materially detrimental to the Company or its subsidiaries. As of December 31, 2013 the Company had 74 banking locations. At December 31, 2013, the Company had approximately $55,957 invested in premises and equipment.

ITEM 3.    LEGAL PROCEEDINGS

       The Company and its subsidiaries may be parties (both plaintiff and defendant) to ordinary litigation incidental to the conduct of business. Management is presently not aware of any material pending or contemplated legal proceedings.

ITEM 4.    MINE SAFETY DISCLOSURES

       Not applicable.

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PART II

ITEM 5.    MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER'S PURCHASES OF EQUITY SECURITIES

Market Information

       The Company's Common Stock is traded on the NASDAQ Stock Market under the symbol MSFG. The Common Stock was held by approximately 5,000 shareholders at March 14, 2014. The quarterly high and low closing prices for the Company's common stock as reported by NASDAQ and quarterly cash dividends declared and paid are set forth in the tables below. All per share data is retroactively restated for all stock dividends and splits.

       The range of known per share prices by calendar quarter, based on actual transactions, excluding commissions, is shown below.

 
  Market Prices  
2013
  Q1
  Q2
  Q3
  Q4
 
   

High

  $ 15.10   $ 14.12   $ 15.53   $ 18.05  

Low

  $ 12.65   $ 12.02   $ 13.81   $ 14.05  

2012

 

Q1


 

Q2


 

Q3


 

Q4


 
   

High

  $ 12.12   $ 12.05   $ 13.00   $ 12.97  

Low

  $ 8.84   $ 10.80   $ 11.27   $ 11.50  
 
 
Cash Dividends
 
2013
  Q1
  Q2
  Q3
  Q4
 
   

  $ 0.06   $ 0.06   $ 0.08   $ 0.08  

2012

 

Q1


 

Q2


 

Q3


 

Q4


 
   

  $ 0.01   $ 0.01   $ 0.03   $ 0.03  

       It is expected that the Company will continue to consider the Company's results of operations, capital levels and other external factors beyond management's control in making the decision to maintain or further raise the dividend.

Issuer Purchases of Equity Securities

       The Company purchased the following equity securities of the Company during the quarter ended December 31, 2013:

Period
  Total Number
of Shares (or
Units) Purchased
(1)

  Average Price Paid Per
Share (or Unit) (1)

  Total Number of Shares
(or Units) Purchased as
Part of Publicly
Announced Plans or
Programs

  Maximum Number (or
Approximate Dollar Value)
of Shares (or Units) That
May Yet Be Purchased
Under the Plans or Programs

 
   

October 1-31, 2013

                0  

November 1-30, 2013

                0  

December 1-31, 2013

                0  
       

Total:

                0  

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Stock Performance Graph

       The following performance graph compares the performance of our common shares to the performance of the NASDAQ Market Index (U.S.) and the NASDAQ Bank Stocks Index for the 60 months ended December 31, 2013. The graph assumes an investment of $100 in each of the Company's common shares, the NASDAQ Market Index (U.S.) and the NASDAQ Bank Stocks Index on December 31, 2008.

GRAPHIC

 
  12/31/08
  12/31/09
  12/31/10
  12/31/11
  12/31/12
  12/31/13
 
   

MainSource Financial Group

    100.00     31.34     64.99     55.16     79.29     113.87  

NASDAQ MARKET INDEX (U.S.)

    100.00     143.88     168.23     165.19     191.47     264.81  

NASDAQ Bank Stocks Index

    100.00     81.49     91.16     79.86     92.46     128.43  

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ITEM 6.    SELECTED FINANCIAL DATA

Selected Financial Data
(Dollar amounts in thousands except per share data)

 
  2013
  2012
  2011
  2010
  2009
 
   

Results of Operations

                               

Net interest income

  $ 91,300   $ 94,082   $ 99,848   $ 101,252   $ 98,008  

Provision for loan losses

    4,534     9,850     17,800     35,250     46,310  

Noninterest income

    43,129     43,891     45,308     41,291     40,050  

Noninterest expense, excluding goodwill impairment

    98,231     94,838     99,805     92,252     87,222  

Goodwill impairment

                    80,310  

Income (loss) before income tax

    31,664     33,285     27,551     15,041     (75,784 )

Income tax (benefit)

    5,319     6,027     3,738     239     (11,645 )

Net income (loss)

    26,345     27,258     23,813     14,802     (64,139 )

Preferred dividends and accretion

    504     2,110     3,054     3,054     2,919  

Net income (loss) available to common shareholders

    25,693     26,505     20,759     11,748     (67,058 )

Dividends paid on common stock

    5,709     1,623     807     805     5,135  

Per Common Share*

   
 
   
 
   
 
   
 
   
 
 

Earnings (loss) per share (basic)

  $ 1.26   $ 1.31   $ 1.03   $ 0.58   $ (3.33 )

Earnings (loss) per share (diluted)

    1.26     1.30     1.03     0.58     (3.33 )

Dividends paid

    0.28     0.08     0.04     0.04     0.26  

Book value — end of period

    14.96     15.21     13.87     12.24     11.84  

Tangible book value — end of period

    11.53     11.72     10.45     8.71     8.16  

Market price — end of period

    18.03     12.67     8.83     10.41     4.78  

At Year End

   
 
   
 
   
 
   
 
   
 
 

Total assets

  $ 2,859,864   $ 2,769,288   $ 2,754,180   $ 2,769,312   $ 2,906,530  

Securities

    891,106     902,341     876,090     806,071     714,607  

Loans, excluding held for sale

    1,671,926     1,553,383     1,534,379     1,680,971     1,885,447  

Allowance for loan losses

    27,609     32,227     39,889     42,605     46,648  

Total deposits

    2,200,628     2,185,054     2,159,900     2,211,564     2,270,650  

Federal Home Loan Bank advances

    247,858     141,052     151,427     152,065     222,265  

Subordinated debentures

    46,394     50,418     50,267     50,117     49,966  

Shareholders' equity

    305,526     323,751     336,553     302,570     294,462  

Financial Ratios

   
 
   
 
   
 
   
 
   
 
 

Return on average assets

    0.95 %   0.99 %   0.85 %   0.51 %   (2.19 )%

Return on average common shareholders' equity

    8.35     8.15     7.44     4.86     (22.61 )

Allowance for loan losses to total loans (year end, excluding held for sale)

    1.65     2.07     2.60     2.53     2.47  

Allowance for loan losses to total non-performing loans (year end)

    104.02     63.04     61.18     46.55     50.60  

Shareholders' equity to total assets (year end)

    10.68     11.69     12.22     10.93     10.13  

Average equity to average total assets

    11.32     12.12     11.46     10.59     11.59  

Dividend payout ratio

    22.22     6.12     3.89     6.85     NM  

*
Adjusted for stock split and dividends

NM
Not meaningful

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ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management's Discussion and Analysis
(Dollar amounts in thousands except per share data)

Forward-Looking Statements

       Except for historical information contained herein, the discussion in this Annual Report includes certain forward-looking statements based upon management expectations. Actual results and experience could differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. The Company disclaims any intent or obligation to update such forward looking statements. Factors which could cause future results to differ from these expectations include the following: general economic conditions; legislative and regulatory initiatives; monetary and fiscal policies of the federal government; deposit flows; the cost of funds; general market rates of interest; interest rates on competing investments; demand for loan products; demand for financial services; changes in accounting policies or guidelines; changes in the quality or composition of the Company's loan and investment portfolios; the Company's ability to integrate acquisitions, and other factors, including the risk factors set forth in Item 1A of this Annual Report on Form 10-K and in other reports we file from time to time with the Securities and Exchange Commission. The Company intends the forward looking statements set forth herein to be covered by the safe harbor provisions for forward looking statements contained in the Private Securities Litigation Reform Act of 1995.

Overview

       MainSource Financial Group, Inc. ("MainSource" or the "Company") is a financial holding company whose principal activity is the ownership and management of its wholly owned subsidiary bank: MainSource Bank headquartered in Greensburg, Indiana (the "Bank"). The Bank operates under an Indiana state charter and is subject to regulation by the Indiana Department of Financial Institutions and the Federal Deposit Insurance Corporation. Non-banking subsidiaries include MainSource Insurance, LLC, Insurance Services Marketing, LLC, MainSource Title, LLC, and MainSource Risk Management, Inc. The first three subsidiaries are subject to regulation by the Indiana Department of Insurance.

Business Strategy

       The Company operates under the broad tenets of a long-term strategic plan ("Plan") designed to improve the Company's financial performance, expand its competitive position and enhance long-term shareholder value. The Plan is premised on the belief of the Company's Board of Directors that it can best promote long-term shareholder interests by pursuing strategies which will continue to preserve its community-focused philosophy. The dynamics of the Plan assure continually evolving goals, with the enhancement of shareholder value being the constant, overriding objective. The extent of the Company's success will depend upon how well it anticipates and responds to competitive changes within its markets, the interest rate environment and other external forces.

Results of Operations

       Net income attributable to common shareholders was $25,693 in 2013, $26,505 in 2012, and $20,759 in 2011. Earnings per common share on a fully diluted basis were $1.26 in 2013, $1.30 in 2012, and $1.03 in 2011. The primary drivers that led to the small decrease in net income in 2013 vs 2012 were decreases in mortgage banking income of $3,128, a decrease in net interest income of $2,782, decreases in securities gains of $1,032, increases in salary and employee benefits of $3,175, an increase in equipment costs of $1,367, and an increase in a prepayment penalty of $926 on an FHLB advance. An increase in rates led to a decrease in mortgage refinancing activity. The reduction in the Company's yield on earnings assets was not completely offset by the reduction in the Company's cost of funds. As a result of favorable pricing in 2012 vs 2013, the Company had fewer securities gains taken in 2013. The increase in employee and benefit costs was a result of the new markets the Company entered in the second half of 2012 and 2013. The increase in equipment costs is a result of several technology initiatives which enhance the customer experience with the Company. Finally, the Company paid off a FHLB advance early and incurred a prepayment penalty which was slightly higher than the penalty incurred in 2012. Offsetting these decreases were lower loan loss provision expense of $5,316, higher trust and investment product fees of $1,106, a reduction of OREO losses of $820, a reduction in FDIC assessment of $784, and a reduction in marketing expenses of $737. Credit losses continued to decline and new impaired loans decreased in 2013. An increase in financial advisors as a result of 2012 acquisitions resulted in higher trust and investment product fees. OREO losses continued to decline as a result of a reduced amount of OREO property. FDIC premiums lowered as a result of a lower rate for the Company's premiums. Finally, a reduction in marketing expenses was a result of fewer branches in new markets in 2013 versus 2012 which required additional marketing dollars.

       The primary drivers that led to the increase in net income in 2012 vs 2011were lower loan loss provision expense of $7,950, reduced consultant expenses of $5,397, higher mortgage banking income of $4,376, an increase in service charge income of $1,668,

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a reduction in FDIC premiums of $1,479, and smaller losses on OREO property of $1,385. Credit losses continued to decline and new impaired loans decreased in 2012. The third party consulting fees paid in 2011 were an increase in consultant expenses. A reduction in interest rates in 2012 led to increased mortgage refinancing activity. Continued emphasis on new account growth generated additional service charge income. FDIC premiums lowered as a result of a lower rate for the Company's premiums. Finally, OREO losses declined as a result of a reduced amount of OREO property. Offsetting these items was a reduction in securities gains of $9,990, lower net interest income of $5,766, and a prepayment penalty of $1,313 on a FHLB advance. As a result of favorable pricing, the Company recorded gains during 2011 on the sale of securities at a higher level than 2012. The reduction in the Company's yield on earnings assets was not completely offset by the reduction in the Company's cost of funds. The Company paid off a FHLB advance early and incurred a prepayment penalty.

Net Interest Income

       Net interest income and net interest margin are influenced by the volume and yield or cost of earning assets and interest-bearing liabilities. Tax equivalent net interest income of $98,310 in 2013 decreased from $101,054 in 2012. Net interest margin, on a fully-taxable equivalent basis, was 3.91% for 2013 compared to 4.07% for the same period a year ago. The Company was unable to match reductions in its yield on earning assets with a corresponding reduction in its cost of funds, as the cost of funds has floored. The Company experienced loan growth in 2013 which somewhat mitigated the reduction in its yield. The Company was also able to continue to lower the interest paid on deposit accounts. The Federal Reserve Bank continues to target the fed funds rate at 0%-.25%.

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       The following table summarizes net interest income (on a tax-equivalent basis) for each of the past three years.

Average Balance Sheet and Net Interest Analysis (Taxable Equivalent Basis)*

 
  2013
  2012
  2011
 
 
     
Assets
  Average
Balance

  Interest
  Average
Rate

  Average
Balance

  Interest
  Average
Rate

  Average
Balance

  Interest
  Average
Rate

 
 
     

Short-term investments

  $ 12,413     35     0.28 % $ 48,712     134     0.28 % $ 69,960     167     0.24 %

Federal funds sold and money market accounts

    11,298     29     0.26     10,811     30     0.28     16,644     48     0.29  

Securities

                                                       

Taxable

    576,959     11,873     2.06     567,437     12,510     2.20     523,760     16,040     3.06  

Non-taxable*

    314,120     18,841     6.00     302,040     18,707     6.19     304,366     19,100     6.28  
       

Total securities

    891,079     30,714     3.45     869,477     31,217     3.59     828,126     35,140     4.24  

Loans**

                                                       

Commercial*

    909,099     46,242     5.09     889,313     50,523     5.68     959,550     55,905     5.83  

Residential real estate

    411,054     18,188     4.42     393,844     19,969     5.07     380,255     21,970     5.78  

Consumer

    277,544     13,081     4.71     270,459     13,867     5.13     276,660     15,566     5.63  
       

Total loans

    1,597,697     77,511     4.85     1,553,616     84,359     5.43     1,616,465     93,441     5.78  
       

Total earning assets

    2,512,487     108,289     4.31     2,482,616     115,740     4.66     2,531,195     128,796     5.09  
       

Cash and due from banks

    42,522                 43,107                 40,444              

Unrealized gains (losses) on securities

    21,489                 41,035                 26,222              

Allowance for loan losses

    (29,563 )               (37,626 )               (42,583 )            

Premises and equipment, net

    55,988                 50,710                 49,920              

Intangible assets

    70,296                 68,704                 70,006              

Accrued interest receivable and other assets

    113,431                 112,177                 115,695              
                                                   

Total assets

  $ 2,786,650               $ 2,760,723               $ 2,790,899              
                                                   
                                                   

Liabilities

                                                       

Interest-bearing deposits DDA, savings, and money market accounts

  $ 1,375,556     1,448     0.11   $ 1,321,901     2,138     0.16   $ 1,294,274     4,275     0.33  

Certificates of deposit

    415,176     3,479     0.84     494,142     5,499     1.11     631,270     9,836     1.56  
       

Total interest-bearing deposits

    1,790,732     4,927     0.28     1,816,043     7,637     0.42     1,925,544     14,111     0.73  

Short-term borrowings

    33,238     70     0.21     30,514     104     0.34     30,946     161     0.52  

Subordinated debentures

    49,000     1,675     3.42     49,000     1,825     3.72     49,000     1,737     3.54  

Notes payable and FHLB borrowings

    155,834     3,307     2.12     148,466     5,120     3.45     150,814     5,754     3.82  
       

Total interest-bearing liabilities

    2,028,804     9,979     0.49     2,044,023     14,686     0.72     2,156,304     21,763     1.01  

Demand deposits

    414,084                 348,858                 288,908              

Other liabilities

    28,263                 33,354                 25,734              
                                                   

Total liabilities

    2,471,151                 2,426,235                 2,470,946              

Shareholders' equity

    315,499                 334,488                 319,953              
                                                   

Total liabilities and shareholders' equity

  $ 2,786,650     9,979     0.40 *** $ 2,760,723     14,686     0.59 *** $ 2,790,899     21,763     0.86 ***
                                                   
                                                   
                                 

Net interest income

        $ 98,310     3.91 ****       $ 101,054     4.07 ****       $ 107,033     4.23 ****
                                 
                                 

Conversion of tax exempt income to a fully taxable equivalent basis using a marginal rate of 35%

  $ 7,010                     $ 6,972               $ 7,185        
                                                   

       Security yields are calculated based on amortized cost.

*
Adjusted to reflect income related to securities and loans exempt from Federal income taxes.

**
Nonaccruing loans have been included in the average balances.

***
Total interest expense divided by total earning assets.

****
Net interest income divided by total earning assets.

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       The following table sets forth for the periods indicated a summary of the changes in interest income and interest expense resulting from changes in volume and changes in rates.

Volume/Rate Analysis of Changes in Net Interest Income
(Tax Equivalent Basis)

 
  2013 OVER 2012   2012 OVER 2011  
 
  Volume
  Rate
  Total
  Volume
  Rate
  Total
 
   

Interest income

                                     

Loans

  $ 2,340   $ (9,188 ) $ (6,848 ) $ (3,547 ) $ (5,535 ) $ (9,082 )

Securities

    764     (1,267 )   (503 )   1,688     (5,611 )   (3,923 )

Federal funds sold and money market funds

    1     (2 )   (1 )   (16 )   (2 )   (18 )

Short-term investments

    (102 )   3     (99 )   (66 )   33     (33 )
           

Total interest income

    3,003     (10,454 )   (7,451 )   (1,941 )   (11.115 )   (13,056 )
           

Interest expense

   
 
   
 
   
 
   
 
   
 
   
 
 

Interest-bearing DDA, savings, and money market accounts

  $ 84   $ (774 ) $ (690 ) $ 89   $ (2,226 ) $ (2,137 )

Certificates of deposit

    (794 )   (1,226 )   (2,020 )   (1,873 )   (2,464 )   (4,337 )

Borrowings

    314     (2,161 )   (1,847 )   (89 )   (602 )   (691 )

Subordinated debentures

        (150 )   (150 )       88     88  
           

Total interest expense

    (396 )   (4,311 )   (4,707 )   (1,873 )   (5,204 )   (7,077 )
           

Change in net interest income

    3,399     (6,143 )   (2,744 )   (68 )   (5,911 )   (5,979 )

Change in tax equivalent adjustment

                38                 (213 )
                                   

Change in net interest income before tax equivalent adjustment

              $ (2,782 )             $ (5,766 )
                                   
                                   

       Variances not attributed to rate or volume are allocated between rate and volume in proportion to the relationship of the absolute dollar amount of the change in each.

Provision for Loan Losses

       The Company expensed $4,534, $9,850, and $17,800 in provision for loan losses in 2013, 2012, and 2011 respectively. This level of provision allowed the Company to maintain an adequate allowance for loan losses. This topic is discussed in detail under the heading "Loans, Credit Risk and the Allowance and Provision for Loan Losses".

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Non-interest Income and Expense

 
   
   
   
  Percent Change  
 
  2013
  2012
  2011
  13/12
  12/11
 
   

Non-interest income

                               

Mortgage banking

  $ 6,799   $ 9,927   $ 5,551     -31.5%     78.8%  

Trust and investment product fees

    4,756     3,650     3,250     30.3%     12.3%  

Service charges on deposit accounts

    20,427     19,815     18,147     3.1%     9.2%  

Net realized gains on securities sales

    835     1,367     11,357     -38.9%     -88.0%  

Increase in cash surrender value of life insurance

    1,378     1,206     1,200     14.3%     0.5%  

Interchange income

    7,056     6,540     6,225     7.9%     5.1%  

Gain/(loss) on sale of OREO

    (539 )   (1,359 )   (2,744 )   60.3%     50.5%  

Other

    2,417     2,745     2,322     -11.9%     18.2%  
                   

Total non-interest income

  $ 43,129   $ 43,891   $ 45,308     -1.7%     -3.1%  
                   
                   

Non-interest expense

                               

Salaries and employee benefits

  $ 52,165   $ 48,990   $ 49,950     6.5%     -1.9%  

Net occupancy

    7,139     6,769     6,686     5.5%     1.2%  

Equipment

    9,931     8,564     7,822     16.0%     9.5%  

Intangibles amortization

    1,868     1,835     1,939     1.8%     -5.4%  

Telecommunications

    1,796     1,729     1,991     3.9%     -13.2%  

Stationery, printing, and supplies

    1,190     1,337     1,510     -11.0%     -11.5%  

FDIC assessment

    1,711     2,495     3,974     -31.4%     -37.2%  

Marketing

    3,660     4,397     4,057     -16.8%     8.4%  

Collection expenses

    3,300     3,768     4,334     -12.4%     -13.1%  

Consultant expense

    1,582     1,150     6,547     37.6%     -82.4%  

Prepayment penalty on FHLB advance

    2,239     1,313         70.5%     NA  

Interchange expense

    1,918     1,591     1,465     20.6%     8.6%  

Other

    9,732     10,900     9,530     -10.7%     14.4%  
                   

Total non-interest expense

  $ 98,231   $ 94,838   $ 99,805     3.6%     -5.0%  
                   
                   

Non-interest Income

       Non-interest income was $43,129 for 2013 compared to $43,891 for the same period in 2012, a decrease of $762 or 1.7%. Decreases in mortgage banking income, securities gains, and other income (primarily title insurance revenue) were the primary causes of the decrease. These decreases were offset by increases in service charges on deposit accounts, interchange income, trust and investment product fees, lower losses on the sale of OREO, and an increase in the cash surrender value of life insurance. An increase in interest rates in 2013 led to decreased mortgage activity and title revenue. As a result of favorable pricing, the Company recorded gains during 2012 on the sale of securities at a higher level than 2013. Continued emphasis on new account growth generated additional service charge and interchange income. The Company acquired two brokerage firms in late 2012 which resulted in higher trust and investment product fees in 2013. OREO losses declined as a result of a reduced amount of OREO properties.

       Non-interest income was $43,891 for 2012 compared to $45,308 for the same period in 2011, a decrease of $1,417 or 3.1%. Increases in mortgage banking income, service charge on deposit accounts, lower losses on the sale of OREO, trust and investment product fees, and interchange income were the primary causes of the increase. These increases were offset by a reduction in securities gains. A reduction in interest rates in 2012 led to increased mortgage refinancing activity. Continued emphasis on new account growth generated additional service charge and interchange income. OREO losses declined as a result of a reduced amount of OREO property as well as more timely appraisals when the property is initially placed in OREO. As a result of favorable pricing, the Company recorded gains during 2011 on the sale of securities at a higher level than 2012.

Non-interest Expense

       Total non-interest expense was $98,231 in 2013 compared to $94,838 in 2012, an increase of $3,393 or 3.6%. The increase was primarily attributable to increases in salaries and employee benefits, occupancy and equipment costs, a prepayment penalty on a FHLB advance, consultant expenses, and interchange expense. Salaries and employee benefit and occupancy costs increased as a result of the full year effect of de novo branches in 2012 and the opening of several more offices in 2013. The increase in equipment costs is a result of several technology initiatives which enhance the customer experience. The Company paid off a FHLB advance early and incurred a prepayment penalty of $2,239. However, the payoff of this advance should lower interest expense costs by approximately $675 on an annual basis. Consultant expenses increased due to several revenue enhancement initiatives suggested by

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the consultants. The increase in interchange expenses is a direct correlation with the increase in interchange income. Offsetting these increases were decreases in FDIC expenses, marketing expense, collection expense, and other expense. FDIC premiums lowered as a result of a lower multiplier for the Company's premiums. Marketing expenses decreased as the Company did not enter any markets in 2013 that required a large outlay of marketing dollars. Collection expenses decreased due to the continued reduction in new problem loans. The reduction in other expense is primarily attributable to professional/legal expenses connected with the Company's participation in the U.S. Department of the Treasury secondary public offering of the Company's preferred stock in 2012.

       Total non-interest expense was $94,838 in 2012 compared to $99,805 in 2011, a decrease of $4,967 or 5.0%. The decrease was primarily attributable to a reduction in consultant expenses of $5,397. During 2011 the Company completed an efficiency project with the aid of a third party consulting firm. Almost all of the Company's departments and corresponding headcount were reviewed, as well as the entire organizational structure of the Company. As a result of the project, many of the non-interest expense categories showed reductions in 2012. These included salaries and employee benefits, telecommunications, and stationary and printing costs. Other categories also showing reductions were intangibles amortization, FDIC assessment, and collection expenses. FDIC premiums lowered as a result of a lower multiplier for the Company's premiums. Collection expenses decreased due to a reduction in new problem loans compared to 2011. Offsetting these decreases were increases in occupancy, equipment, marketing, other expenses, and a prepayment penalty on a FHLB advance. Occupancy, equipment, and marketing expenses increased primarily due to opening of three de novo branches in 2012. The largest contributor to other expense was expenses related to tax credit properties. Lastly, the Company paid off a FHLB advance early and incurred a prepayment penalty of $1,313.

Income Taxes

       The effective tax rate was 16.8% in 2013, 18.1% in 2012, and 13.6% in 2011. The decrease in the Company's effective rate from 2012 to 2013 was due primarily from a decrease in taxable income with the tax exempt income and tax credits remaining the same from year to year. The increase in the effective rate from 2011 to 2012 was primarily due to an increase in taxable income in 2012. The Company and its subsidiaries file consolidated income tax returns.

Balance Sheet

       At December 31, 2013, total assets were $2,859,864 compared to $2,769,288 at December 31, 2012, an increase of $91 million. Increases in loans ($119 million) were offset by a decrease in investment securities ($11 million).

Loans, Credit Risk and the Allowance and Provision for Loan Losses

       Loans remain the Company's largest concentration of assets and continue to represent the greatest potential risk. The loan underwriting standards observed by the Bank are viewed by management as a means of controlling problem loans and the resulting charge-offs. The Company also believes credit risks may be elevated if undue concentrations of loans in specific industry segments and to out-of-area borrowers are incurred. Accordingly, the Company's Board of Directors regularly monitors such concentrations to determine compliance with its loan concentration policy. The Company believes it has no undue concentrations of loans.

       Total loans (excluding those held for sale) increased by $118,543 in 2013. Almost all categories of loans experienced loan growth in 2013 as the effects of the 2008 recession have subsided and businesses are starting to borrow. The Company has also invested in additional lending personnel and opened branches in new markets which has contributed to the growth. Residential real estate loans continue to represent the largest portion of the total loan portfolio and were 45% of total loans at December 31, 2013 compared to 48% of total loans at the end of 2012.

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       The following table details the Company's loan portfolio by type of loan.

Loan Portfolio

 
  2013
  2012
  2011
  2010
  2009
 
   

Types of loans

                               

Commercial and industrial

    167,270   $ 130,787   $ 107,538   $ 163,651   $ 195,509  

Agricultural production financing

    45,057     38,232     32,325     36,596     41,889  

Farm real estate

    87,166     68,013     58,424     37,634     45,332  

Commercial real estate mortgage

    520,317     480,879     509,887     525,578     551,670  

Construction and development

    45,638     31,694     37,078     84,152     142,472  

Residential real estate mortgage

    760,184     753,230     730,374     759,409     813,602  

Consumer

    46,294     50,548     58,753     73,951     94,973  
       

Total loans

  $ 1,671,926   $ 1,553,383   $ 1,534,379   $ 1,680,971   $ 1,885,447  
       
       

       The following table indicates the amounts of loans (excluding residential and commercial mortgages and consumer loans) outstanding as of December 31, 2013 which, based on remaining scheduled repayments of principal, are due in the periods indicated.

Maturities and Sensitivity to Changes in Interest Rates of Commercial and Construction Loans

 
  Due:
  Within
1 Year

  1-5 Years
  Over
5 years

  Total
 
   

Loan Type

                             

Commercial and industrial

      $ 44,635   $ 80,296   $ 42,339   $ 167,270  

Agricultural production financing

        31,324     10,801     2,932     45,057  

Construction and development

        11,628     15,135     18,875     45,638  
           

Totals

      $ 87,587   $ 106,232   $ 64,146   $ 257,965  
           
           

Percent

        34%     41%     25%     100%  
           
           

Rate Sensitivity

                             

Fixed Rate

      $ 13,132   $ 75,558   $ 24,496   $ 113,186  

Variable Rate

        110,178     23,170     11,431     144,779  
           

Totals

      $ 123,310   $ 98,728   $ 35,927   $ 257,965  
           
           

       Loans are placed on "non-accrual" status when, in management's judgment, the collateral value and/or the borrower's financial condition does not justify accruing interest. As a general rule, commercial, commercial real estate, residential, and consumer loans are reclassified to non-accrual status at or before becoming 90 days past due. Interest previously recorded is reversed and charged against current income. Subsequent interest payments collected on non-accrual loans are thereafter applied as a reduction of the loan's principal balance. Non-performing loans were $26,543 as of December 31, 2013 compared to $51,118 as of December 31, 2012 and represented 1.59% of total loans at December 31, 2013 versus 3.29% one year ago. The significant reduction in 2013 is a result of the Company's continued emphasis on reducing the amount of non-performing loans and the upgrade of three credits that had been classified as troubled debt restructurings that became performing loans in 2013.

       The following table details the Company's non-performing loans as of December 31 for the years indicated.

Non-performing Loans

 
  2013
  2012
  2011
  2010
  2009
 
   

Non-accruing loans

  $ 22,341   $ 35,451   $ 41,528   $ 68,236   $ 77,074  

Troubled debt restructurings (accruing)

    4,188     15,102     20,402     22,250     11,843  

Accruing loans contractually past due 90 days or more

    14     565     3,266     990     3,279  
       

Total

  $ 26,543   $ 51,118   $ 65,196   $ 91,476   $ 92,196  
       

% of total loans

    1.59%     3.29%     4.25%     5.44%     4.89%  

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       A reconciliation of non-performing assets ("NPA") for 2013 and 2012 is as follows:

 
  2013
  2012
 
   

Beginning Balance — NPA — January 1

  $ 57,795   $ 80,731  

Non-accrual

             

Add: New non-accruals

    15,538     34,863  

Less: To accrual/payoff/restructured

    (15,491 )   (18,142 )

Less: To OREO

    (4,005 )   (5,286 )

Less: Charge offs

    (9,152 )   (17,512 )
       

Increase/(Decrease): Non-accrual loans

    (13,110 )   (6,077 )

Other Real Estate Owned (OREO)

             

Add: New OREO properties

    4,005     5,286  

Less: OREO sold

    (5,708 )   (12,089 )

Less: OREO losses (write-downs)

    (854 )   (1,976 )
       

Increase/(Decrease): OREO

    (2,557 )   (8,779 )

Increase/(Decrease): Repossessions

        (79 )

Increase/(Decrease): 90 Days Delinquent

    (551 )   (2,701 )

Increase/(Decrease): TDR's

    (10,914 )   (5,300 )
       

Total NPA change

    (27,132 )   (22,936 )
       

Ending Balance — NPA — December 31

  $ 30,663   $ 57,795  
       
       

       At December 31, 2013, only two of the non-accrual loan balances were greater than $1,000. These loans are real estate backed loans. The Company is working with these borrowers in an attempt to minimize its losses. In the course of resolving problem loans, the Company may choose to restructure the contractual terms of certain loans. The Company attempts to work out an alternative payment schedule with the borrower in order to avoid foreclosure actions. Any loans that are modified are reviewed by the Company to identify if a troubled debt restructuring has occurred, which is when for economic or legal reasons related to a borrower's financial difficulties, the Company grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status and could include reduction of the stated interest rate, other than normal market rate adjustments, extension of maturity dates, or reduction of principal balance or accrued interest. The decision to restructure a loan, versus aggressively enforcing the collection of the loan, may benefit us by increasing the ultimate probability of collection. The Company reviews each relationship before it grants the concession to insure the creditor can comply with the new terms. To date, most of the concessions have been extensions of maturity dates. The provision for loan losses was $4,534 in 2013, $9,850 in 2012, and $17,800 in 2011. The Company's provision for loan losses continued to decline in 2013 due to the stabilization of problem credits. New non-accrual loans declined over 55% in 2013. Net charge-offs were $9,152 in 2013 compared to $17,512 in 2012 and $20,516 in 2011. As a percentage of average loans, net charge-offs equaled 0.57%, 1.13%, and 1.27% in 2013, 2012, and 2011, respectively.

       Potential problem loans are identified on the Company's watch list and consist of loans that require close monitoring by management and are not necessarily considered classified credits by regulators. Credits may be considered as a potential problem loan for reasons that are temporary or correctable, such as for a deficiency in loan documentation or absence of current financial statements of the borrower. Potential problem loans may also include credits where adverse circumstances are identified that may affect the borrower's ability to comply with the contractual terms of the loan. Other factors which might indicate the existence of a potential problem loan include the delinquency of a scheduled loan payment, deterioration in a borrower's financial condition identified in a review of periodic financial statements, a decrease in the value of the collateral securing the loan, or a change in the economic environment in which the borrower operates. Substandard commercial loans that were not classified as non-accrual were $27,277 at December 31, 2013 and $28,785 at December 31, 2012, a decrease of $1,563. These loans which are $250 or greater are reviewed at least quarterly by senior management. This review includes monitoring how the borrower is performing versus their workout plan, obtaining and reviewing the borrower's financial information, and monitoring collateral values. Management believes these loans were well secured and had adequate allowance allocations at December 31, 2013.

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Summary of the Allowance for Loan Losses

 
  2013
  2012
  2011
  2010
  2009
 
   

Balance at January 1

  $ 32,227   $ 39,889   $ 42,605   $ 46,648   $ 34,583  

Chargeoffs

                               

Commercial

    1,152     1,946     2,211     8,190     8,686  

Commercial real estate mortgage

    6,353     13,553     16,954     29,177     21,140  

Residential real estate mortgage

    2,349     3,547     3,093     2,220     1,899  

Consumer

    2,648     3,286     2,636     2,859     4,477  
       

Total Chargeoffs

    12,502     22,332     24,894     42,446     36,202  
       

Recoveries

                               

Commercial

    341     543     1,172     518     350  

Commercial real estate mortgage

    1,087     2,432     1,371     873     226  

Residential real estate mortgage

    650     265     648     524     37  

Consumer

    1,272     1,580     1,187     1,238     1,344  
       

Total Recoveries

    3,350     4,820     4,378     3,153     1,957  
       

Net Chargeoffs

    9,152     17,512     20,516     39,293     34,245  

Provision for loan losses

    4,534     9,850     17,800     35,250     46,310  
       

Balance at December 31

  $ 27,609   $ 32,227   $ 39,889   $ 42,605   $ 46,648  
       
       

Net Chargeoffs to average loans

    0.57%     1.13%     1.27%     2.21%     1.73%  

Provision for loan losses to average loans

    0.28%     0.63%     1.10%     1.98%     2.35%  

Allowance to total loans at year end

    1.65%     2.07%     2.60%     2.53%     2.47%  
       
       

       Although the allowance for loan losses is available for any loan that, in management's judgment, should be charged off, the following table details the allowance for loan losses by loan category and the percent of loans in each category compared to total loans at December 31.

Allocation of the Allowance for Loan Losses

 
  2013   2012   2011   2010   2009  
December 31
  Amount
  Percent
of loans
to total
loans

  Amount
  Percent
of loans
to total
loans

  Amount
  Percent
of loans
to total
loans

  Amount
  Percent
of loans
to total
loans

  Amount
  Percent
of loans
to total
loans

 
   

Real estate

                                                             

Residential

  $ 3,409     39%   $ 3,180     40%   $ 2,972     38%   $ 2,281     45%   $ 9,449     43%  

Farm real estate

    194     5     722     4     456     3     740     2     647     2  

Commercial

    17,679     39     20,465     41     24,187     45     20,034     31     14,754     29  

Construction and development

    2,337     2     2,970     2     5,833     2     11,879     5     10,205     8  
       

Total real estate

    23,619     85     27,337     87     33,448     88     34,934     83     35,055     82  
       

Commercial

                                                             

Agribusiness

    64     2     166     2     151     1     370     2     1,126     2  

Other commercial

    3,227     10     3,728     8     5,411     7     6,016     10     7,880     11  
       

Total Commercial

    3,291     12     3,894     10     5,562     8     6,386     12     9,006     13  
       

Consumer

    699     3     996     3     879     4     1,285     5     2,587     5  
       

Total

  $ 27,609     100%   $ 32,227     100%   $ 39,889     100%   $ 42,605     100%   $ 46,648     100%  
       
       

       Management maintains a list of loans warranting either the assignment of a specific reserve amount or other special administrative attention. This watch list, together with a listing of all classified loans, non-accrual loans and delinquent loans, is reviewed monthly by management. Additionally, the Company evaluates its consumer and residential real estate loan pools for probable losses incurred based on historical trends, adjusted by current delinquency and non-performing loan levels.

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       The Company has both internal and external loan review personnel who annually review approximately 50% of all loans. External loan review personnel examine the top 100 commercial credit relationships. This equates to approximately all relationships above $1,750.

       The ability to absorb loan losses promptly when problems are identified is invaluable to a banking organization. Most often, losses incurred as a result of prompt, aggressive collection actions are much lower than losses incurred after prolonged legal proceedings. Accordingly, the Company observes the practice of quickly initiating stringent collection efforts in the early stages of loan delinquency.

       The adequacy of the allowance for loan losses is reviewed at least quarterly. The determination of the provision amount in any period is based upon management's continuing review and evaluation of loan loss experience, changes in the composition of the loan portfolio, classified loans including non-accrual and impaired loans, current economic conditions, the amount of loans presently outstanding, and the amount and composition of loan growth. The Company's allowance for loan losses was $27,609, or 1.65% of total loans, at December 31, 2013 compared to $32,227, or 2.07% of total loans, at the end of 2012. This $4,618 decrease in the allowance was due in large part to write-offs in 2013 that had an allowance allocated in 2012 as well as continued monitoring of problem loans.

Securities, at Fair Value

 
  December 31,  
 
  2013
  2012
  2011
 
   

Available for Sale

                   

U.S. Government-sponsored entities

  $ 798   $ 1,638   $  

State and municipal

    331,112     337,939     344,877  

Mortgage-backed

    550,738     554,278     522,271  

Equity and other

    8,458     8,486     8,942  
       

Total securities

  $ 891,106   $ 902,341   $ 876,090  
       
       

       Securities offer flexibility in the Company's management of interest rate risk, and are the primary means by which the Company provides liquidity and responds to changing maturity characteristics of assets and liabilities. The Company's investment policy prohibits trading activities and does not allow investment in high-risk derivative products or junk bonds.

       As of December 31, 2013, all of the securities are classified as available for sale ("AFS") and are carried at fair value with unrealized gains and losses, net of taxes, excluded from earnings and reported as a separate component of shareholders' equity. A net unrealized gain of $1,746 was recorded to adjust the AFS portfolio to current market value at December 31, 2013 compared to a net unrealized gain of $39,582 at December 31, 2012.

Securities
(Carrying Values at December 31)

 
  Within
1 Year

  2-5 Yrs
  6-10 Yrs
  Beyond
10 Years

  Total 2013
 
   

Available for sale

                               

US government agency

  $   $   $ 798   $   $ 798  

State and municipal

    14,434     54,844     123,194     138,640     331,112  

Mortgage-backed securities

    11     6,367     23,604     520,756     550,738  

Other securities

    507     2,019         993     3,519  
       

Total available for sale

  $ 14,952   $ 63,230   $ 147,596   $ 660,389   $ 886,167  
       
       

Weighted average yield*

    6.48%     5.80%     5.36%     2.81%     3.45%  

*
Adjusted to reflect income related to securities exempt from federal income taxes.

       Amounts in the table above are based on scheduled maturity dates. Variable interest rates are subject to change not less than annually based upon certain interest rate indexes. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Equity securities of $4,939 do not have contractual maturities and are excluded from the table above.

       As of December 31, 2013, there were no corporate bonds and other securities which represented more than 10% of shareholders' equity.

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       For 2013 the tax equivalent yield of the investment securities portfolio was 3.45%, compared to 3.59% and 4.24% for 2012 and 2011, respectively. The average life of the Company's investment securities portfolio was 4.77 years at December 31, 2013. During 2013 the investment portfolio decreased slightly in size as the Company's excess cash was invested in loans as loan demand increased significantly. Cash flows from security sales and normal monthly principal pay downs were reinvested at materially lower yields leading to a sizable decline in portfolio yield. The reinvestments were focused on a balanced approach between a likely long term low interest rate horizon and protection against cash flow extensions when rates do move higher. This investment strategy will allow the portfolio to meet cash needs for future loan growth.

       The Company and its investment advisor monitor the securities portfolio on at least a quarterly basis for other-than-temporary impairment ("OTTI"). The amount of the OTTI recognized in earnings depends on whether the Company intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss. If an entity intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment's amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors is recognized in other comprehensive income, net of applicable taxes. In 2012, the Company recorded a $500 impairment loss on one of its equity securities. There was no OTTI recorded in 2013.

       In December, 2013, banking regulators published the final rules under Section 619 of the Dodd-Frank Act (commonly referred to as the "Volcker Rule"). Under the Volcker Rule, collateralized debt obligations, including pooled trust preferred securities, are no longer a permissible investment and would have to be divested prior to July 15, 2015. On January 14, 2014, banking regulators released their interim final rule regarding the Volcker Rule and its impact on collateralized debt obligations. Under the interim final rule, regulators clarified the final rule and said that collateralized debt obligations primarily backed by trust preferred securities issued by depository institutions could continue to be held by banks. The Company was informed from an outside third party that it may be holding one security that would need to be divested by July 15, 2015. At December 31, 2013, the security had an amortized cost of $4,394 with an unrealized gain of $64. The Company is currently conducting further research on this security to see if it is a permissible holding.

Sources of Funds

       The Company relies primarily on customer deposits and securities sold under agreement to repurchase ("repurchase agreements") along with shareholders' equity to fund earning assets. Federal Home Loan Bank ("FHLB") advances are used to provide additional funding. The Company also attempts to obtain deposits through branch and whole bank acquisitions.

       Deposits generated within local markets provide the major source of funding for earning assets. Average total deposits were 87.8% and 87.2% of total average earning assets for 2013 and 2012, respectively. Total interest-bearing deposits averaged 81.2% and 83.9% of average total deposits during 2013 and 2012. Management is continuing its efforts to increase the percentage of transaction-related deposits to total deposits due to the positive effect on earnings.

       Repurchase agreements are high denomination investments utilized by public entities and commercial customers as an element of their cash management responsibilities. During 2013, repurchase agreements averaged $29,132, with an average cost of 0.17%.

       Another source of funding is the Federal Home Loan Bank (FHLB). The Company had FHLB advances of $247,858 outstanding at December 31, 2013. These advances have interest rates ranging from 0.3% to 4.8% (see Note 12 to the consolidated financial statements for the maturity schedule of these advances). The Company averaged $153,672 in FHLB advances during 2013 compared to $146,365 during 2012. This increase in the average balance of FHLB borrowings was primarily due to the increased loans generated by the Company in 2013 which created the need for other funding sources. One final source of funding is federal funds purchased. The Company had $9,200 of federal funds purchased as of December 31, 2013 and $8,725 at December 31, 2012.

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Average Deposits

 
  2013
  2012
  2011
 
 
     
 
   
   
  Amount
  Rate
  Amount
  Rate
 
   

Demand

  $ 414,084         $ 348,858         $ 288,908        

Interest Bearing Demand

    879,921     0.12 %   866,493     0.17 %   843,523     0.34 %

Savings/Money Markets

    495,635     0.09     455,408     0.14     450,751     0.30  

Certificates of Deposit

    415,176     0.84     494,142     1.11     631,270     1.56  
                                 

Totals

  $ 2,204,816     0.22 % $ 2,164,901     0.35 % $ 2,214,452     0.64 %
                                 
                                 

       As of December 31, 2013, certificates of deposit and other time deposits of $100 or more mature as follows:

 
  3 months or less
  4-6 months
  6-12 months
  over 12 months
  Total
 
   

Amount

  $ 21,984   $ 41,094   $ 21,256   $ 44,798   $ 129,132  

Percent

    17%     32%     16%     35%        

Capital Resources

       The Federal Reserve Board and other regulatory agencies have adopted risk-based capital guidelines that assign risk weightings to assets and off-balance sheet items. The Company's core capital ("Tier 1") consists of common shareholders' equity adjusted for unrealized gains or losses on available for sale (AFS) securities plus limited amounts of Trust Preferred Securities less goodwill and intangible assets. Total capital consists of core capital, certain debt instruments and a portion of the allowance for loan losses. At December 31, 2013, Tier 1 capital to average assets was 10.1%. Total capital to risk-weighted assets was 16.7%. Both ratios exceed all required ratios established for bank holding companies. Risk-adjusted capital levels of the Bank also exceed regulatory definitions of well-capitalized institutions.

       The Trust Preferred Securities (which are classified as subordinated debentures) currently qualify as Tier 1 capital or core capital with respect to the Company under the risk-based capital guidelines established by the Federal Reserve. Under such guidelines, capital received from the proceeds of the sale of these securities cannot constitute more than 25% of the total Tier 1 capital of the Company. Consequently, the amount of Trust Preferred Securities in excess of the 25% limitation constitutes Tier 2 capital, or supplementary capital, of the Company. As of December 31, 2013, all of the Company's Trust Preferred Securities qualify as Tier 1 capital. The Company redeemed $4,124 of these securities in December, 2013.

       Common shareholders' equity is impacted by the Company's decision to categorize its securities portfolio as available for sale (AFS). Securities in this category are carried at fair value, and common shareholders' equity is adjusted to reflect unrealized gains and losses, net of taxes.

       The Company declared and paid common dividends of $.28 per share in 2013 compared to $.08 in 2012 and $.04 2011. Book value per common share decreased to $14.96 at December 31, 2013 compared to $15.21 at the end of 2012. The decrease is primarily the result of the reduction in the AFS equity adjustment. The net adjustment for AFS securities increased book value per share by $0.06 at December 31, 2013 and increased book value per share by $1.27 at December 31, 2012. Depending on market conditions, the adjustment for AFS securities can cause significant fluctuations in shareholders' equity.

       On January 16, 2009, the Company entered into an agreement with the United States Department of Treasury (the "Treasury Department") as part of the Treasury Department's Capital Purchase Program. Under this agreement, the Company issued to the Treasury Department 57,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A ("preferred stock") and a warrant to purchase up to 571,906 shares ("warrant shares") of the Company's common stock. Like stock options, the warrant issued through the Capital Purchase Program is potentially dilutive. The average stock price for the Company for 2013 and 2012 was $14.58 and $11.45 per share respectively, and the warrant issued in 2009 has an exercise price of $14.95 per share. This resulted in no additional potentially dilutive shares during 2013 and 2012.

       On March 28, 2012, the U.S. Department of the Treasury priced its secondary public offering of 57,000 shares of the Company's Preferred Stock. The Company successfully bid for the purchase of 21,030 shares of the Preferred Stock. During the remainder of 2013, the Company purchased the remaining shares of the preferred stock. See Note 2 in the Consolidated Financial Statements for more information related to the sale of the Preferred Stock.

Liquidity

       Liquidity management involves maintaining sufficient cash levels to fund operations and to meet the requirements of borrowers, depositors and creditors. Higher levels of liquidity bear higher corresponding costs, measured in terms of lower yields on short-term, more liquid earning assets and higher interest expense involved in extending liability maturities. Liquid assets include cash and cash

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equivalents, loans and securities maturing within one year and money market instruments. In addition, the Company holds approximately $871,215 of AFS securities maturing after one year, which can be sold to meet liquidity needs.

       Maintaining a relatively stable funding base, which is achieved by diversifying funding sources, supports liquidity, extends the contractual maturity of liabilities, and limits reliance on volatile short-term purchased funds. Short-term funding needs may arise from declines in deposits or other funding sources, funding of loan commitments and requests for new loans. The Company's strategy is to fund assets to the maximum extent possible with core deposits, which provide a sizable source of relatively stable low-cost funds. The Company defines core deposits as all deposits except certificates of deposits greater than $100. Average core deposits funded approximately 82.2% of total earning assets during 2013 and approximately 80.6% in 2012.

       Management believes the Company has sufficient liquidity to meet all reasonable borrower, depositor and creditor needs in the present economic environment. The Company has not received any directives from regulatory authorities that would materially affect liquidity, capital resources or operations.

Contractual Obligations as of December 31, 2013

 
  Total
  Less than
1 Year

  1-3 Years
  3-5 Years
  More than
5 Years

 
   

Time Deposits

  $ 378,456   $ 239,612   $ 101,604   $ 29,867   $ 7,373  

FHLB Advances

    247,858     133,294     39,805     74,725     34  

Subordinated Debentures

    46,394                 46,394  

Other Borrowings

    38,594     38,594              

Operating Lease Commitments

    4,778     1,087     1,590     856     1,245  
       

Total

  $ 716,080   $ 412,587   $ 142,999   $ 105,448   $ 55,046  
       
       

Off-balance Sheet Arrangements

       The Bank incurs off-balance sheet risks in the normal course of business in order to meet the financing needs of its customers. These risks derive from commitments to extend credit and standby letters of credit. Off-balance sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. See Note 16 to the Consolidated Financial Statements for additional details on the Company's off-balance sheet arrangements.

Interest Rate Risk Management

       Interest rate risk is the exposure of the Company's financial condition to adverse changes in market interest rates. In an effort to estimate the impact of sustained interest rate movements to the Company's earnings, the Company monitors interest rate risk through computer-assisted simulation modeling of its net interest income. The Company's simulation modeling monitors the potential impact to net interest income under various interest rate scenarios. The Company's objective is to actively manage its asset/liability position within a one-year interval and to limit the risk in any of the interest rate scenarios to a reasonable level of tax-equivalent net interest income within that interval. The Company monitors compliance within established guidelines of the Funds Management Policy. See Item 7A. Quantitative and Qualitative Disclosures About Market Risk section for further discussion regarding interest rate risk.

Critical Accounting Policies

       The accounting and reporting policies of the Company comply with accounting principles generally accepted in the United States and conform to general practices within the banking industry. These policies require estimates and assumptions. Changes in underlying factors, assumptions, or estimates in any of these areas could have a material impact on the Company's future financial condition and results of operations. In management's opinion, some of these areas have a more significant impact than others on the Company's financial reporting. These areas currently include accounting for securities, the allowance for loan losses, goodwill, income taxes, and mortgage servicing rights.

       Securities Valuation and Other Than Temporary Impairment of Securities — Securities available-for-sale are carried at fair value, with unrealized holding gains and losses reported separately in accumulated other comprehensive income (loss), net of tax. In estimating the fair value for the majority of securities, fair values are based on observable market prices of the same or similar investments. The majority of securities are priced by an independent third party pricing service. Equity securities that do not have readily determinable fair values are carried at cost. When the fair value of securities is less than its amortized cost for an extended period, the Company will decide if the security is other than temporarily impaired. If the security is deemed to be other than temporarily impaired, an impairment charge will be recorded through earnings. In determining whether a market value decline is other than temporary, management considers the reason for the decline, the extent of the decline, the duration of the decline and whether the Company intends to sell or believes it will be required to sell the securities prior to recovery.

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       Allowance for Loan Losses — The level of the allowance for loan losses is based upon management's evaluation of the loan and lease portfolios, past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay (including the timing of future payments), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, and other pertinent factors. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The level of allowance maintained is believed by management to be adequate to cover losses inherent in the portfolio. The allowance is increased by provisions charged to expense and decreased by charge-offs, net of recoveries of amounts previously charged-off.

       Goodwill — Goodwill and intangible assets deemed to have indefinite lives are subject to annual impairment tests. The Company has selected June 30 as its date for annual impairment testing, but will test more frequently if circumstances warrant. No goodwill impairment was identified during testing performed in 2013 or 2012.

       Income taxes — The Company is subject to the income tax laws of the U.S., its states and the municipalities in which it operates. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant government taxing authorities. The Company reviews income tax expense and the carrying value of deferred tax assets; and as new information becomes available, the balances are adjusted as appropriate. In establishing a provision for income tax expense, the Company makes judgments and interpretations about the application of these inherently complex tax laws and also makes estimates about when in the future certain items will affect taxable income in the various tax jurisdictions.

       Mortgage servicing rights — The Company originally records mortgage servicing rights at fair value and amortizes them over the period of the estimated future net servicing income of the underlying loans. The servicing rights are evaluated for impairment based upon the fair value of the rights as compared to the carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual grouping, to the extent that fair value is less than the carrying amount.

New Accounting Matters

       See Note 1 to the Consolidated Financial Statements regarding the adoption of new accounting standards in 2013.

ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

       The Company's exposure to market risk is reviewed on a regular basis by the Credit and Risk Committee of the Board of Directors and by the Boards of Directors of the Company and the Bank. Primary market risks, which impact the Company's operations, are liquidity risk and interest rate risk, as discussed above.

       As discussed previously, the Company monitors interest rate risk by the use of computer simulation modeling to estimate the potential impact on its net interest income under various interest rate scenarios. Another method by which the Company's interest rate risk position can be estimated is by computing estimated changes in its net portfolio value ("NPV"). This method estimates interest rate risk exposure from movements in interest rates by using interest rate sensitivity analysis to determine the change in the NPV of discounted cash flows from assets and liabilities. Computations are based on a number of assumptions, including the relative levels of market interest rates and prepayments in mortgage loans and certain types of investments. These computations do not contemplate any actions management may undertake in response to changes in interest rates, and should not be relied upon as indicative of actual results. In addition, certain shortcomings are inherent in the method of computing NPV. Should interest rates remain or decrease below current levels, the proportion of adjustable rate loans could decrease in future periods due to refinancing activity. In the event of an interest rate change, prepayment levels would likely be different from those assumed in the table. Lastly, the ability of many borrowers to repay their adjustable rate debt may decline during a rising interest rate environment.

       The following tables provide an assessment of the risk to NPV in the event of sudden and sustained 1% and 2% increases and decreases in prevailing interest rates. The table indicates that as of December 31, 2013 the Company's estimated NPV might be expected to increase in the event of a decrease in prevailing interest rates, and might be expected to generally decrease in the event of an increase in prevailing interest rates (dollars in thousands). As of December 31, 2012 the Company's estimated NPV would generally increase in the event of a decrease in prevailing rates and decrease in the event of an increase in prevailing interest rates.

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December 31, 2013

 
   
  $ Amount
  $ Change
  NPV Ratio
  Change
 
   
      +2%     464,119     (79,747 )   17.28%     (155 )
      +1%     502,188     (41,678 )   18.06%     (77 )
      Base     543,866         18.83%      
      -1%     564,909     21,043     18.91%     8  
      -2%     590,260     46,394     19.11%     28  

December 31, 2012

 
   
  $ Amount
  $ Change
  NPV Ratio
  Change
 
   
      +2%     585,912     (67,797 )   21.22%     (88 )
      +1%     619,214     (34,495 )   21.69%     (41 )
      Base     653,709         22.10%      
      -1%     668,411     14,702     21.91%     (19 )
      -2%     771,237     117,528     24.35%     225  

       The above discussion, and the portions of "Management's Discussion and Analysis" in Item 7 of this Report that are referenced in the above discussion contains statements relating to future results of the Company that are considered "forward-looking-statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to, among other things, simulation of the impact on net interest income from changes in interest rates. Actual results may differ materially from those expressed or implied therein as a result of certain risks and uncertainties, including those risks and uncertainties expressed above, those that are described in "Management's Discussion and Analysis" in Item 7 of this Report, those that are described in Item 1 of this Report, "Business," under the caption "Forward-Looking-Statements," and those that are described in Item 1A of this Report, "Risk Factors", all of which discussions are incorporated herein by reference.

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ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

LOGO

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Shareholders
MainSource Financial Group, Inc.
Greensburg, Indiana

       We have audited the accompanying consolidated balance sheets of MainSource Financial Group, Inc. as of December 31, 2013 and 2012 and the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2013. We also have audited MainSource Financial Group, Inc.'s internal control over financial reporting as of December 31, 2013, based on criteria established in the 1992 Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). MainSource Financial Group, Inc.'s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the company's internal control over financial reporting based on our audits.

       We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

       A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

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

       In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of MainSource Financial Group, Inc. as of December 31, 2013 and 2012, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2013, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, MainSource Financial Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on criteria established in the 1992 Internal Control — Integrated Framework issued by the COSO.

    /s/ Crowe Horwath LLP

Indianapolis, Indiana
March 14, 2014

 

 

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MAINSOURCE FINANCIAL GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Dollar amounts in thousands except per share data)

 
  December 31,
2013

  December 31,
2012

 
   

Assets

             

Cash and due from banks

  $ 55,826   $ 58,100  

Money market funds and federal funds sold

    5,494     7,550  
       

Cash and cash equivalents

    61,320     65,650  

Securities available for sale

    891,106     902,341  

Loans held for sale

    5,999     17,025  

Loans, net of allowance for loan losses of $27,609 and $32,227

    1,644,317     1,521,156  

Restricted stock, at cost

    15,629     15,639  

Premises and equipment, net

    55,957     54,101  

Goodwill

    64,900     63,947  

Purchased intangible assets

    5,125     6,993  

Cash surrender value of life insurance

    61,292     59,410  

Interest receivable and other assets

    54,219     63,026  
       

Total assets

  $ 2,859,864   $ 2,769,288  
       
       

Liabilities

   
 
   
 
 

Deposits

             

Noninterest bearing

  $ 436,550   $ 405,167  

Interest bearing

    1,764,078     1,779,887  
       

Total deposits

    2,200,628     2,185,054  

Other borrowings

    38,594     34,519  

Federal Home Loan Bank (FHLB) advances

    247,858     141,052  

Subordinated debentures

    46,394     50,418  

Other liabilities

    20,864     34,494  
       

Total liabilities

    2,554,338     2,445,537  

Commitments and contingent liabilities (Notes 1 and 16)

   
 
   
 
 

Shareholders' equity

   
 
   
 
 

Preferred stock, no par value

             

Authorized shares — 400,000 and 400,000

             

Issued shares — 0 and 57,000;

             

Outstanding shares — 0 and 15,100

             

Aggregate liquidation preference $0 and $15,100

        14,918  

Common stock $.50 stated value:

             

Authorized shares — 100,000,000

             

Issued shares — 20,940,298 and 20,859,027

             

Outstanding shares — 20,417,224 and 20,304,525

    10,508     10,450  

Treasury stock — 523,074 and 554,502 shares, at cost

    (8,495 )   (9,043 )

Additional paid-in capital

    224,793     224,096  

Retained earnings

    77,586     57,602  

Accumulated other comprehensive income

    1,134     25,728  
       

Total shareholders' equity

    305,526     323,751  
       

Total liabilities and shareholders' equity

  $ 2,859,864   $ 2,769,288  
       
       

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

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MAINSOURCE FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31, 2013, 2012, AND 2011
(Dollar amounts in thousands except per share data)

 
  2013
  2012
  2011
 
   

Interest income

                   

Loans, including fees

  $ 77,095   $ 83,934   $ 92,941  

Securities

                   

Taxable

    11,873     12,510     16,040  

Tax exempt

    12,247     12,160     12,415  

Other interest income

    64     164     215  
       

Total interest income

    101,279     108,768     121,611  
       

Interest expense

                   

Deposits

    4,927     7,637     14,111  

Federal Home Loan Bank advances

    3,307     5,120     5,754  

Subordinated debentures

    1,675     1,825     1,737  

Other borrowings

    70     104     161  
       

Total interest expense

    9,979     14,686     21,763  
       

Net interest income

    91,300     94,082     99,848  

Provision for loan losses

    4,534     9,850     17,800  
       

Net interest income after provision for loan losses

    86,766     84,232     82,048  

Non-interest income

                   

Service charges on deposit accounts

    20,427     19,815     18,147  

Interchange income

    7,056     6,540     6,225  

Mortgage banking

    6,799     9,927     5,551  

Trust and investment product fees

    4,756     3,650     3,250  

Increase in cash surrender value of life insurance

    1,378     1,206     1,200  

Net realized gains on securities (includes $835, $1,867, and $11,357 accumulated other comprehensive income (AOCI) reclassifications for realized net gains on available for sale securities)

    835     1,867     11,357  

(Loss) on sale and write-down of OREO

    (539 )   (1,359 )   (2,744 )

Other-than-temporary loss

                   

Total impairment loss

        (500 )    

Loss recognized in other comprehensive income

             
       

Net impairment loss recognized in earnings

        (500 )    

Other income

    2,417     2,745     2,322  
       

Total non-interest income

    43,129     43,891     45,308  

Non-interest expense

                   

Salaries and employee benefits

    52,165     48,990     49,950  

Net occupancy

    7,139     6,769     6,686  

Equipment

    9,931     8,564     7,822  

Intangibles amortization

    1,868     1,835     1,939  

Telecommunications

    1,796     1,729     1,991  

Stationery printing and supplies

    1,190     1,337     1,510  

FDIC assessment

    1,711     2,495     3,974  

Marketing

    3,660     4,397     4,057  

Collection expense

    3,300     3,768     4,334  

Prepayment penalty on FHLB advance

    2,239     1,313      

Consultant expense

    1,582     1,150     6,547  

Interchange expense

    1,918     1,591     1,465  

Other expenses

    9,732     10,900     9,530  
       

Total non-interest expense

    98,231     94,838     99,805  
       

Income before income tax

    31,664     33,285     27,551  

Income tax expense (includes $284, $635, and $3,861 income tax expense from AOCI reclassification items)

    5,319     6,027     3,738  
       

Net income

  $ 26,345   $ 27,258   $ 23,813  

Preferred dividends and discount accretion

    (504 )   (2,110 )   (3,054 )

Redemption of preferred stock

    (148 )   1,357      
       

Net income attributable to common shareholders

  $ 25,693   $ 26,505   $ 20,759  
       
       

Net income per common share:

                   

Basic

  $ 1.26   $ 1.31   $ 1.03  

Diluted

  $ 1.26   $ 1.30   $ 1.03  

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

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MAINSOURCE FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
YEARS ENDED DECEMBER 31, 2013, 2012, AND 2011
(Dollar amounts in thousands except per share data)

 
  2013
  2012
  2011
 
   

Net income

  $ 26,345   $ 27,258   $ 23,813  

Other comprehensive income/(loss):

                   

Unrealized holding gains/(losses) on securities available for sale

    (37,001 )   5,731     32,025  

Reclassification adjustment for (gains) included in net income

    (835 )   (1,867 )   (11,357 )

Reclassification adjustment for other than temporary loss included in net income

        500      

Tax effect

    13,242     (1,528 )   (7,234 )
       

Other comprehensive income/(loss)

    (24,594 )   2,836     13,434  
       

Comprehensive income

  $ 1,751   $ 30,094   $ 37,247  
       
       

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

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MAINSOURCE FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2013, 2012, AND 2011
(Dollar amounts in thousands except per share data)

 
   
  Common Stock    
   
   
   
   
 
 
   
   
  Additional
Paid-in
Capital

   
  Accumulated
Other
Comprehensive
Income/(Loss)

   
 
 
  Preferred
Stock

  Shares
Outstanding

  Amount
  Treasury
Stock

  Retained
Earnings

  Total
 
   

Balance, January 1, 2011

  $ 56,183     20,136,188   $ 10,394   $ (9,367 ) $ 223,134   $ 12,768   $ 9,458   $ 302,570  

Net income

                                  23,813           23,813  

Other comprehensive income

                                        13,434     13,434  

Stock option expense

                            72                 72  

Dividends — common stock ($.04 per share)

                                  (807 )         (807 )

Restricted stock award

          46,244     5           96                 101  

Director retainer award

          23,782     12           208                 220  

Dividends — preferred stock

                                  (2,850 )         (2,850 )

Accretion of preferred stock discount

    204                             (204 )          
       

Balance, December 31, 2011

    56,387     20,206,214     10,411     (9,367 )   223,510     32,720     22,892     336,553  
       

Net income

                                  27,258           27,258  

Other comprehensive income