Note 6 Allowance for Loan and Lease Losses

Management reviews the appropriateness of the allowance for loan and lease losses (“allowance”) on a regular basis. Management considers the accounting policy relating to the allowance to be a critical accounting policy, given the inherent uncertainty in evaluating the levels of the allowance required to cover credit losses in the portfolio and the material effect that assumptions could have on the Company’s results of operations. The Company has developed a methodology to measure the amount of estimated loan loss exposure inherent in the loan portfolio to assure that an appropriate allowance is maintained. The Company’s methodology is based upon guidance provided in SEC Staff Accounting Bulletin No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues and allowance allocations are calculated in accordance with ASC Topic 310, Receivables and ASC Topic 450, Contingencies.

The Company’s methodology for determining and allocating the allowance for loan and lease losses focuses on ongoing reviews of larger individual loans and leases, historical net charge-offs, delinquencies in the loan and lease portfolio, the level of impaired and nonperforming loans, values of underlying loan and lease collateral, the overall risk characteristics of the portfolios, changes in character or size of the portfolios, geographic location, current economic conditions, changes in capabilities and experience of lending management and staff, and other relevant factors. The various factors used in the methodologies are reviewed on a regular basis.

At least annually, management reviews all commercial and commercial real estate loans exceeding a certain threshold and assigns a risk rating. The Company uses an internal loan rating system of pass credits, special mention loans, substandard loans, doubtful loans, and loss loans (which are fully charged off). The definitions of “special mention”, “substandard”, “doubtful” and “loss” are consistent with banking regulatory definitions. Factors considered in assigning loan ratings include: the customer’s ability to repay based upon customer’s expected future cash flow, operating results, and financial condition; the underlying collateral, if any; and the economic environment and industry in which the customer operates. Special mention loans have potential weaknesses that if left uncorrected may result in deterioration of the repayment prospects and a downgrade to a more severe risk rating. A substandard loan credit has a well-defined weakness which makes payment default or principal exposure likely, but not yet certain. There is a possibility that the Company will sustain some loss if the deficiencies are not corrected. A doubtful loan has a high possibility of loss, but the extent of the loss is difficult to quantify because of certain important and reasonably specific pending factors.

At least quarterly, management reviews all commercial and commercial real estate loans and leases and agriculturally related loans with an outstanding principal balance of over $500,000 that are internally risk rated special mention or worse, giving consideration to payment history, debt service payment capacity, collateral support, strength of guarantors, local market trends, industry trends, and other factors relevant to the particular borrowing relationship. Through this process, management identifies impaired loans. For loans and leases considered impaired, estimated exposure amounts are based upon collateral values or discounted cash flows. For commercial loans, commercial mortgage loans, and agricultural loans not specifically reviewed, and for homogenous loan portfolios such as residential mortgage loans and consumer loans, estimated exposure amounts are assigned based upon historical net loss experience and current charge-off trends, past due status, and management’s judgment of the effects of current economic conditions on portfolio performance. In determining and assigning historical loss factors to the various homogeneous portfolios, the Company calculates average net losses over a period of time and compares this average to current levels and trends to ensure that the calculated average loss factor is reasonable.

Since the methodology is based upon historical experience and trends as well as management’s judgment, factors may arise that result in different estimations. Significant factors that could give rise to changes in these estimates may include, but are not limited to, changes in economic conditions in the local area, concentration of risk, changes in interest rates, and declines in local property values. While management’s evaluation of the allowance as of December 31, 2011, considers the allowance to be appropriate, under adversely different conditions or assumptions, the Company would need to increase the allowance.

Changes in the allowance for loan and lease losses at December 31 are summarized as follows:

(in thousands)	2011			2010			2009
Allowance at beginning of year	$	27,832		$	24,350		$	18,672
Provisions charged to operations		8,945			8,507			9,288
Recoveries on loans and leases		1,048			1,110			624
Loans and leases charged-off		(10,232	)		(6,135	)		(4,234	)
Total	$	27,593		$	27,832		$	24,350

The following tables detail activity in the allowance for loan and lease losses by portfolio segment for the twelve months ended December 31, 2011 and 2010. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.

December 31, 2011
(in thousands)	Commercial and Industrial			Commercial Real Estate			Residential Real Estate			Consumer and Other			Finance Leases			Total
Allowance for credit losses:

Beginning balance	$	7,824		$	14,445		$	3,526		$	1,976		$	61		$	27,832

Charge-offs		(2,403	)		(4,488	)		(2,730	)		(608	)		(3	)		(10,232	)
Recoveries		424			280			33			311			0			1,048
Provision		3,091			2,425			3,418			30			(19	)		8,945
Ending Balance	$	8,936		$	12,662		$	4,247		$	1,709		$	39		$	27,593

December 31, 2010
(in thousands)	Commercial and Industrial			Commercial Real Estate			Residential Real Estate			Consumer and Other			Finance Leases			Total
Allowance for credit losses:

Beginning balance	$	7,304		$	11,119		$	3,616		$	2,230		$	81		$	24,350

Charge-offs		(3,265	)		(1,167	)		(791	)		(912	)		0			(6,135	)
Recoveries		464			225			85			336			0			1,110
Provision		3,321			4,268			616			322			(20	)		8,507
Ending Balance	$	7,824		$	14,445		$	3,526		$	1,976		$	61		$	27,832

At December 31, 2011and 2010, the allocation of the allowance for loan and lease losses summarized on the basis of the Company’s impairment methodology was as follows:

(in thousands)	Commercial and Industrial		Commercial Real Estate		Residential Real Estate		Consumer and Other		Finance Leases		Total

December 31, 2011
Individually evaluated for impairment	$	2,863	$	667	$	0	$	0	$	0	$	3,530
Collectively evaluated for impairment		6,073		11,995		4,247		1,709		39		24,063
Ending balance	$	8,936	$	12,662	$	4,247	$	1,709	$	39	$	27,593

December 31, 2010
Individually evaluated for impairment	$	682	$	2,554	$	0	$	0	$	0	$	3,236
Collectively evaluated for impairment		7,142		11,891		3,526		1,976		61		24,596
Ending balance	$	7,824	$	14,445	$	3,526	$	1,976	$	61	$	27,832

The recorded investment in loans and leases summarized on the basis of the Company’s impairment methodology as of December 31, 2011 and 2010 was as follows:

(in thousands)	Commercial and Industrial		Commercial Real Estate		Residential Real Estate		Consumer and Other		Finance Leases		Total

December 31, 2011
Individually evaluated for impairment	$	10,161	$	22,150	$	388	$	0	$	0	$	32,699
Collectively evaluated for impairment		474,533		744,084		660,924		63,748		6,489		1,949,778
Total	$	484,694	$	766,234	$	661,312	$	63,748	$	6,489	$	1,982,477

December 31, 2010
Individually evaluated for impairment	$	5,617	$	29,622	$	0	$	0	$	0	$	35,239
Collectively evaluated for impairment		469,733		696,840		626,797		73,425		9,949		1,876,744
Total	$	475,350	$	726,462	$	626,797	$	73,425	$	9,949	$	1,911,983

A loan is impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans consist of our non-homogenous nonaccrual loans, and all loans restructured in a troubled debt restructuring (TDR). Specific reserves on individually identified impaired loans that are not collateral dependent are measured based on the present value of expected future cash flows discounted at the original effective interest rate of each loan. For loans that are collateral dependent, impairment is measured based on the fair value of the collateral less estimated selling costs, and such impaired amounts are generally charged off. The majority of impaired loans are collateral dependant impaired loans that have limited exposure or require limited specific reserves because of the amount of collateral support with respect to these loans, and previous charge-offs. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured. In these cases, interest is recognized on a cash basis. Interest income recognized on impaired loans and leases, all collected in cash, was $0 for 2011, $252,000 for 2010, and $234,000 for 2009.

The following table summarizes the recorded investment in impaired loans.

The following table summarizes the recorded investment in impaired loans.

December 31, 2011
(in thousands)	Recorded Investment			Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance

Commercial and industrial
Agriculture		$	0	$	0	$	0	$	145	$	0
Commercial and industrial other		$	2,489	$	2,915	$	0	$	2,939	$	0
Commercial real estate
Construction			9,018		14,628		0		3,284		0
Commercial real estate other			12,150		12,496		0		12,408		0
Residential real estate
Residential real estate other			388		388		0		155		0
Subtotal		$	24,045	$	30,427	$	0	$	18,931	$	0

With related allowance

Commercial and industrial
Commercial and industrial other			4,197		4,197		2,113		2,938		0
Commercial real estate
Construction			3,475		3,475		750		8,462		0
Commercial real estate other			982		982		667		2,521		0
Subtotal		$	8,654	$	8,654	$	3,530	$	13,921	$	0
Total		$	32,699	$	39,081	$	3,530	$	32,852	$	0

December 31, 2010
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Recognized		Interest Income Recognized
With no related allowance

Commercial and industrial
Agriculture	$	724	$	724	$	0	$	769	$	5
Commercial and industrial other		3,393		4,336		0		4,113		37
Commercial real estate
Commercial real estate other		15,675		15,831		0		16,421		210
Subtotal	$	19,792	$	20,891	$	0	$	21,303	$	252

With related allowance

Commercial and industrial
Commercial and industrial other		1,500		1,500		682		1,500		0
Commercial real estate
Construction		12,816		13,400		1,927		12,827		0
Commercial real estate other		1,131		1,303		627		1,236		0
Subtotal	$	15,447	$	16,203	$	3,236	$	15,563	$	0
Total	$	35,239	$	37,094	$	3,236	$	36,866	$	252

The average recorded investment in impaired loans was $17.0 million in 2009.

Loans are considered modified in a TDR when, due to a borrower’s financial difficulties, the Company makes a concession(s) to the borrower that it would not otherwise consider. When modifications are provided for reasons other than as a result of the financial distress of the borrower, these loans are not classified as TDRs or impaired. These modifications primarily include, among others, an extension of the term of the loan, and granting a period when interest-only payments can be made and interest caught up with the principal payments made over the remaining term of the loan or at maturity, among other things.

The following tables present loans by class modified in 2011 as troubled debt restructurings.

Troubled Debt Restructuring

December 31, 2011	Twelve months ended
	Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
(in thousands)
Commercial and industrial
Commercial and industrial other		13		8,411		8,335
Commercial real estate
Commercial real estate other		11		7,046		7,046
Residential real estate
Mortgages		4		445		445
Total		28	$	15,902	$	15,826

The Company recognized TDRs with a balance of $15.9 million for the twelve month period ended December 31, 2011. At December 31, 2011 the Company has specific reserves of $2.6 million. The Company is not committed to lend additional amounts as of December 31, 2011 to customers with outstanding loans that are classified as TDRs.

There was a charge-offs taken on one commercial relationship totaling $76,000 for the twelve months ended December 31, 2011.

A loan that was restructured as a TDR is considered to be in payment default once it is 90 days contractually past due under the modified terms. During the year ended December 31, 2011, only one TDR, a commercial mortgage loan with a recorded balance of $65,000 that had been restructured in the 12 months prior to December 31, 2011, became 90 days or more past due.

The following table presents credit quality indicators (internal risk grade) by class of commercial loans, commercial real estate loans and agricultural loans as of December 31, 2011 and 2010.

December 31, 2011 (in thousands)	Commercial and Industrial Other		Commercial and Industrial Agriculture		Commercial Real Estate Other		Commercial Real Estate Agriculture		Commercial Real Estate Construction		Total
Internal risk grade:
Pass	$	377,083	$	65,795	$	602,915	$	50,333	$	28,232	$	1,124,358
Special Mention		14,488		1,059		25,743		1,022		9,844		52,156
Substandard		25,557		712		35,707		1,716		9,228		72,920
Doubtful		0		0		1,494		0		0		1,494
Total	$	417,128	$	67,566	$	665,859	$	53,071	$	47,304	$	1,250,928

December 31, 2010 (in thousands)	Commercial and Industrial Other		Commercial and Industrial Agriculture		Commercial Real Estate Other		Commercial Real Estate Agriculture		Commercial Real Estate Construction		Total
Internal risk grade:
Pass	$	355,153	$	53,302	$	537,195	$	37,894	$	45,703	$	1,029,247
Special Mention		28,478		3,570		43,138		5,734		0		80,920
Substandard		25,801		9,046		39,125		4,857		12,816		91,645
Total	$	409,432	$	65,918	$	619,458	$	48,485	$	58,519	$	1,201,812

The following table presents credit quality indicators by class of residential real estate loans and by class of consumer loans as of December 31, 2011 and 2010. Nonperforming loans include nonaccrual, impaired and loans 90 days past due and accruing interest, all other loans are considered performing.

(in thousands)	Residential Home Equity		Residential Mortgages		Consumer Indirect		Consumer Other		Total
Performing	$	159,734	$	494,316	$	32,548	$	30,961	$	717,559
Nonperforming		1,544		5,718		239		0		7,501
Total	$	161,278	$	500,034	$	32,787	$	30,961	$	725,060

December 31, 2010

(in thousands)	Residential Home Equity		Residential Mortgages		Consumer Indirect		Consumer Other		Total
Performing	$	162,968	$	454,350	$	41,352	$	31,757	$	690,427
Nonperforming		1,797		7,682		316		0		9,795
Total	$	164,765	$	462,032	$	41,668	$	31,757	$	700,222