UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

x    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended September 30, 2013

or

¨     TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the transition period from to

Commission File Number 001-33872

Susquehanna Bancshares, Inc.

(Exact Name of Registrant as Specified in Its Charter)

Pennsylvania	23-2201716
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)
26 North Cedar St., Lititz, Pennsylvania	17543
(Address of Principal Executive Offices)	(Zip Code)

Registrant’s telephone number, including area code (717) 626-4721

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  x    No  ¨ 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.)

Yes  x    No  ¨ 

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

Large Accelerated Filer	x	Accelerated Filer	¨
Non-Accelerated Filer	¨  (Do not check if a smaller reporting company)	Smaller Reporting Company	¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  ¨    No  x 

As of October 28, 2013, there were 187,239,664 shares of the registrant’s common stock outstanding, par value $2.00 per share.

SUSQUEHANNA BANCSHARES, INC.
TABLE OF CONTENTS
			Page
PART I. FINANCIAL INFORMATION			3
	Item 1 Financial Statements (Unaudited)		3
		Consolidated Balance Sheets as of September 30, 2013 and December 31, 2012	3
		Consolidated Statements of Income for the three and nine months ended September 30, 2013 and 2012	4
		Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2013 and 2012	5
		Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012	6
		Consolidated Statements of Changes in Shareholders’ Equity for the nine months ended September 30, 2013 and 2012	7
		Notes to Consolidated Financial Statements	8
	Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations		56
	Item 3 Quantitative and Qualitative Disclosures About Market Risk		76
	Item 4 Controls and Procedures		78
PART II. OTHER INFORMATION			79
	Item 1 Legal Proceedings		79
	Item 1A Risk Factors		79
	Item 2 Unregistered Sales of Equity Securities and Use of Proceeds		79
	Item 3 Defaults Upon Senior Securities		79
	Item 4 Mine Safety Disclosures		79
	Item 5 Other Information		80
	Item 6 Exhibits		81
SIGNATURES			82
EXHIBIT INDEX			83

2

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
SUSQUEHANNA BANCSHARES, INC. AND SUBSIDIARIES
Consolidated Balance Sheets (Unaudited)
					September 30,		December 31,
					2013		2012
					(in thousands, except share data)
Assets
	Cash and due from banks				$	377,730	$	277,042
	Unrestricted short-term investments					30,663		39,550
			Cash and cash equivalents			408,393		316,592
	Interest-bearing deposits held by consolidated variable interest entities that can be used only to settle
		obligations of the consolidated variable interest entities				2,138		4,423
	Restricted short-term investments					44,928		75,203
	Securities available for sale					2,483,375		2,577,901
	Restricted investment in bank stocks					160,787		152,434
	Loans and leases, net of deferred costs and fees					13,300,309		12,728,082
	Loans held by consolidated variable interest entities that can be used only to settle obligations of the
		consolidated variable interest entities				76,145		166,659
			Less: Allowance for loan and lease losses			166,740		184,020
				Net loans and leases		13,209,714		12,710,721
	Premises and equipment, net					189,096		188,983
	Other real estate and foreclosed assets					18,729		31,017
	Accrued interest receivable					41,715		40,304
	Bank-owned life insurance					449,419		450,270
	Goodwill					1,275,439		1,270,359
	Intangible assets with finite lives					33,666		41,332
	Deferred income tax assets					7,921		4,685
	Other assets					155,830		173,443
				Total Assets	$	18,481,150	$	18,037,667
Liabilities and Shareholders’ Equity
	Deposits:
		Noninterest-bearing			$	1,871,461	$	1,973,664
		Interest-bearing				10,850,224		10,606,382
				Total deposits		12,721,685		12,580,046
	Federal Home Loan Bank short-term borrowings					1,510,000		1,098,000
	Other short-term borrowings					688,456		817,577
	Federal Home Loan Bank long-term borrowings					83,272		101,062
	Other long-term debt					250,229		251,021
	Junior subordinated debentures					154,983		154,927
	Long-term debt of consolidated variable interest entities for which creditors do not have recourse to
		Susquehanna’s general credit				52,592		107,453
	Accrued interest, taxes, and expenses payable					101,040		81,808
	Deferred income tax liabilities					52,214		14,475
	Other liabilities					187,331		235,389
				Total Liabilities		15,801,802		15,441,758
	Shareholders’ equity:
		Common stock, $2.00 par value, 400,000,000 shares authorized; Issued: 187,491,129 at
			September 30, 2013, and 186,811,642 at December 31, 2012			374,982		373,623
		Treasury stock, at cost, 265,858 at September 30, 2013, and 257,556 at December 31, 2012				(1,918)		(1,850)
		Additional paid-in capital				1,651,382		1,645,958
		Retained earnings				717,850		615,436
		Accumulated other comprehensive loss, net of taxes of $34,983  and $20,672, respectively				(62,948)		(37,258)
				Total Shareholders’ Equity		2,679,348		2,595,909
				Total Liabilities and Shareholders’ Equity	$	18,481,150	$	18,037,667
The accompanying notes are an integral part of these consolidated financial statements.

3

SUSQUEHANNA BANCSHARES, INC. AND SUBSIDIARIES
Consolidated Statements of Income (Unaudited)
			Three Months Ended				Nine Months Ended
			September 30,				September 30,
			2013		2012		2013		2012
				(in thousands, except per share data)
Interest Income:
	Loans and leases, including fees		$	155,596	$	163,979	$	475,926	$	478,483
	Securities:
		Taxable		10,641		12,277		30,584		38,025
		Tax-exempt		3,527		3,620		10,682		11,003
		Dividends		1,297		1,157		3,609		3,252
	Short-term investments			16		36		87		101
		Total interest income		171,077		181,069		520,888		530,864
Interest Expense:
	Deposits:
		Interest-bearing demand and savings		4,190		5,091		13,604		16,761
		Time		10,229		12,085		33,115		35,518
	Federal Home Loan Bank short-term borrowings			3,915		3,245		10,738		9,302
	Other short-term borrowings			2,242		2,206		6,548		6,507
	Federal Home Loan Bank long-term borrowings			284		308		888		668
	Other long-term debt			4,268		8,992		12,743		26,174
		Total interest expense		25,128		31,927		77,636		94,930
Net interest income				145,949		149,142		443,252		435,934
Provision for loan and lease losses				5,000		16,000		29,000		51,000
Net interest income, after provision for loan and lease losses				140,949		133,142		414,252		384,934
Noninterest Income:
	Service charges on deposit accounts			9,514		9,013		27,533		25,270
	Vehicle origination and servicing fees			2,907		2,470		8,668		6,620
	Wealth management commissions and fees			12,606		11,923		38,285		35,823
	Commissions on property and casualty insurance sales			3,872		3,158		12,774		12,145
	Other commissions and fees			5,276		5,387		17,199		14,830
	Income from bank-owned life insurance			1,493		1,726		4,521		4,868
	Mortgage banking revenue			2,237		5,113		10,345		12,969
	Net realized (loss) gain on sales of securities			2		31		(51)		1,633
	Other			3,436		4,840		13,789		8,829
		Total noninterest income		41,343		43,661		133,063		122,987
Noninterest Expenses:
	Salaries and employee benefits			61,879		62,236		191,801		184,718
	Occupancy			11,352		11,350		33,721		33,886
	Furniture and equipment			3,661		3,823		10,986		11,749
	Professional and technology services			7,173		4,916		18,733		14,591
	Advertising and marketing			3,092		2,947		8,664		9,288
	FDIC insurance			5,421		5,275		13,760		15,222
	Legal fees			1,774		2,012		5,454		5,972
	Amortization of intangible assets			2,502		3,337		8,823		9,253
	Vehicle lease disposal			1,193		1,401		3,796		4,981
	Merger related			0		1,500		0		16,297
	Loss on extinguishment of debt			0		5,451		0		5,451
	Other			19,654		18,662		59,430		53,332
		Total noninterest expenses		117,701		122,910		355,168		364,740
Income before income taxes				64,591		53,893		192,147		143,181
Provision for income taxes				20,300		17,161		59,809		45,183
Net Income			$	44,291	$	36,732	$	132,338	$	97,998
Earnings per common share:
		Basic	$	0.24	$	0.20	$	0.71	$	0.54
		Diluted	$	0.24	$	0.20	$	0.70	$	0.54
Cash dividends per common share			$	0.08	$	0.06	$	0.16	$	0.14
Average common shares outstanding:
		Basic		187,096		186,214		186,840		181,735
		Diluted		188,109		187,004		187,816		182,487
The accompanying notes are an integral part of these consolidated financial statements.

4

SUSQUEHANNA BANCSHARES, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income (Unaudited)
				Three Months Ended				Nine Months Ended
				September 30,				September 30,
				2013		2012		2013		2012
					(in thousands)				(in thousands)
Net Income				$	44,291	$	36,732	$	132,338	$	97,998
Other comprehensive income:
	Change in unrealized gain (loss) on securities available for sale				3,144		20,905		(56,148)		27,699
			Tax effect and reclassification adjustment		(1,151)		(7,570)		20,206		(10,060)
					1,993		13,335		(35,942)		17,639
	Non-credit related unrealized gain on other-than-temporarily
		impaired debt securities			237		136		378		1,877
			Tax effect		(87)		(50)		(139)		(688)
					150		86		239		1,189
	Change in unrealized gain (loss) on cash flow hedges				1,309		(2,614)		15,795		(6,389)
			Tax effect		(478)		955		(5,765)		2,250
					831		(1,659)		10,030		(4,139)
	Adjustment to postretirement benefit obligations				0		0		(26)		0
			Tax effect		0		0		9		0
					0		0		(17)		0
Total other comprehensive income (loss)					2,974		11,762		(25,690)		14,689
Total comprehensive income				$	47,265	$	48,494	$	106,648	$	112,687
The accompanying notes are an integral part of these consolidated financial statements.

5

SUSQUEHANNA BANCSHARES, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows (Unaudited)
			Nine Months Ended
			September 30,
			2013		2012
				(in thousands)
Cash Flows from Operating Activities:
	Net income		$	132,338	$	97,998
	Adjustments to reconcile net income to net cash provided by operating activities:
		Depreciation, amortization, and accretion		40,157		37,839
		Provision for loan and lease losses		29,000		51,000
		Realized loss (gain) on available-for-sale securities, net		51		(1,633)
		Deferred income tax expense		49,433		20,485
		Gain on sale of loans and leases		(11,422)		(14,084)
		Gain on sale of foreclosed assets		(519)		(2,681)
		Loss on sale of fixed assets		428		0
		Mortgage loans originated for sale		(412,448)		(404,902)
		Proceeds from sale of mortgage loans originated for sale		437,937		404,473
		Increase in cash surrender value of bank-owned life insurance		(6,638)		(4,347)
		Increase in accrued interest receivable		(1,411)		(2,511)
		(Decrease) increase in accrued interest payable		(129)		2,514
		Increase (decrease) in accrued expenses and taxes payable		19,361		(17,841)
		Other, net		(23,249)		24,112
	Net cash provided by operating activities			252,889		190,422
Cash Flows from Investing Activities:
	Net decrease (increase) in restricted short-term investments			32,560		(4,686)
	Activity in available-for-sale securities:
		Sales		33,765		161,668
		Maturities, repayments, and calls		512,267		501,105
		Purchases		(522,871)		(991,689)
	Net increase in restricted investment in bank stock			(8,353)		(4,277)
	Net increase in loans and leases			(549,855)		(304,561)
	Purchase of bank-owned life insurance			(6,050)		(4,087)
	Proceeds from bank-owned life insurance			13,539		6,366
	Proceeds from sale of foreclosed assets			16,845		29,147
	Acquisitions			0		(2,487)
	Additions to premises and equipment, net			(12,360)		(6,619)
	Net cash used in investing activities			(490,513)		(620,120)
Cash Flows from Financing Activities:
	Net increase in deposits			141,639		360,535
	Net (decrease) increase in other short-term borrowings			(129,121)		138,723
	Net increase in short-term FHLB borrowings			412,000		100,000
	Repayment of long-term FHLB borrowings			(16,231)		(13,028)
	Proceeds from issuance of long-term debt			0		150,000
	Repayment of long-term debt			(55,653)		(214,006)
	Proceeds from issuance of common stock			6,783		5,644
	Purchase of treasury stock			(68)		(105)
	Cash dividends paid			(29,924)		(25,284)
	Net cash provided by financing activities			329,425		502,479
Net change in cash and cash equivalents				91,801		72,781
Cash and cash equivalents at January 1				316,592		332,145
Cash and cash equivalents at September 30			$	408,393	$	404,926
Supplemental Disclosure of Cash Flow Information
	Cash paid for interest on deposits and borrowings		$	77,765	$	92,416
	Income tax (refunds) payments			(22,440)		18,607
Supplemental Schedule of Noncash Activities
	Real estate acquired in settlement of loans		$	11,693	$	27,490
The accompanying notes are an integral part of these consolidated financial statements.

6

SUSQUEHANNA BANCSHARES, INC. AND SUBSIDIARIES
Consolidated Statements Of Changes In Shareholders’ Equity (Unaudited)
(In thousands, except share data)
												Accumulated
			Shares of					Additional				Other
			Common	Common		Treasury		Paid-in		Retained		Comprehensive
			Stock	Stock		Stock		Capital		Earnings		Income (Loss)		Total
Balance at January 1, 2012			157,067,887	$	314,136	$	(1,263)	$	1,397,152	$	525,657	$	(46,054)	$	2,189,628
	Total comprehensive income										97,998		14,689		112,687
	Issuance of common stock in Tower Bancorp, Inc. acquisition		30,760,933		61,522				240,590						302,112
	Retirement of common stock related to acquired employee benefit plans		(1,861,580)		(3,723)				3,723						0
	Issuance of common stock and share-based awards under employee
		benefit plans	709,012		1,417				4,227						5,644
	Treasury stock purchased						(105)								(105)
	Cash dividends paid on common stock ($0.14 per share)										(25,284)				(25,284)
Balance at September 30, 2012			186,676,252	$	373,352	$	(1,368)	$	1,645,692	$	598,371	$	(31,365)	$	2,584,682
Balance at January 1, 2013			186,811,642	$	373,623	$	(1,850)	$	1,645,958	$	615,436	$	(37,258)	$	2,595,909
	Total comprehensive income										132,338		(25,690)		106,648
	Issuance of common stock and share-based awards under employee
		benefit plans	679,487		1,359				5,424						6,783
	Treasury stock purchased						(68)								(68)
	Cash dividends paid on common stock ($0.16 per share)										(29,924)				(29,924)
Balance at September 30, 2013			187,491,129	$	374,982	$	(1,918)	$	1,651,382	$	717,850	$	(62,948)	$	2,679,348
The accompanying notes are an integral part of these consolidated financial statements.

7

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

NOTE 1. Summary of Significant Accounting Policies

The information contained in this report is unaudited.

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") for interim financial information.  Certain prior-year amounts have been reclassified to conform to current period classifications and those reclassifications are not material to previously issued financial statements.  In the opinion of management, the information reflects all normal recurring adjustments necessary for a fair statement of results for the three and nine months ended September 30, 2013 and 2012. The year-end balance sheet data was derived from audited financial statements, but does not include all disclosures required by U.S. GAAP. Operating results for the three-month and nine-month periods ended September 30, 2013 are not necessarily indicative of the results that may be expected for the year ending December 31, 2013.

The accounting policies of Susquehanna Bancshares, Inc. and Subsidiaries ("Susquehanna"), as applied in the consolidated interim financial statements presented herein, are substantially the same as those followed on an annual basis as presented on pages 79 through 84 of Susquehanna’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012.

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported and contingent amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenues and expenses during the reporting periods.  Actual results could differ significantly from those estimates.  Material estimates that are particularly susceptible to significant change relate to the estimated residual value of leases; determination of the allowance for loan and lease losses; the fair value of financial instruments, such as loans, investment securities, and derivatives; measurement and assessment of goodwill, intangible assets, and other purchase accounting related adjustments; benefit plan obligations and expenses; and income tax assets, liabilities and expenses.

Recently Adopted Accounting Guidance

In December 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-11, Balance Sheet (Topic 210) - Disclosures about Offsetting Assets and Liabilities. In January 2013, FASB issued ASU 2013-01, Balance Sheet (Topic 210) – Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities. These ASUs require an entity to disclose the nature of its rights of setoff and related arrangements associated with its financial instruments, and derivative instruments accounted for in accordance with Topic 815, Derivatives and Hedging, issued in December 2011. The objective of these ASUs are to make financial statements that are prepared under U.S. GAAP more comparable to those prepared under International Financial Reporting Standards. The new disclosures will give financial statement users information about both gross and net exposures. These ASUs were effective for interim and annual reporting periods after January 1, 2013 and were applied on a retrospective basis.  The adoption of this guidance, in the first quarter of 2013, did not have a material impact on the financial condition, or results of operations, however did result in additional disclosures.  For more information about these disclosures, refer to Note 14. Balance Sheet Offsetting. 

In July 2012, FASB issued ASU 2012-02, Intangibles – Goodwill and Other (Topic 350) – Testing Indefinite – Lived Intangible Assets for Impairment.  This ASU clarifies the assessment options and testing processes previously defined in ASU 2011-08, Intangibles – Goodwill and Other (Topic 350) – Testing Goodwill for Impairment issued in September 2011.  ASU 2012-02 is effective for interim and annual impairment tests performed for fiscal years beginning after September 15, 2012.  The adoption of this guidance, in the first quarter of 2013, did not have a material impact on results of operations or financial condition.

In February 2013, FASB issued ASU 2013-02, Comprehensive Income (Topic 220) – Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.  This ASU requires entities to disclose information regarding reclassification adjustments from accumulated other comprehensive income in their annual financial statements in a single note or on the face of the financial statements.  ASU 2013-02 is effective for interim and annual reporting periods beginning after December 15, 2012.  The adoption of this guidance, in the first quarter of 2013, did not have a material impact on results of operations or financial condition, however did result in additional disclosures.  For more information about these disclosures, refer to Note 9.  Accumulated Other Comprehensive Income.

8

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

In July 2013, FASB issued ASU 2013-10, Derivatives and Hedging (Topic 815) – Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes.  This ASU permits the Fed Funds Effective Swap Rate to be used as a U.S. benchmark interest rate for hedge accounting purposes under Topic 815, in addition to U.S. Treasury interest rates and the London Interbank Offered Rate.  The amendment also removes the restriction on using different benchmark rates for similar hedges.  The adoption of this guidance, in the third quarter of 2013, did not have a material impact on results of operations, financial condition, or disclosures.  For more information, refer to Note 15.  Fair Value Disclosures.

NOTE 2. Acquisitions

On February 17, 2012, Susquehanna acquired all of the outstanding common stock of Tower Bancorp, Inc. (“Tower”), headquartered in Harrisburg, Pennsylvania, through the merger of Tower with and into Susquehanna. The results of operations acquired in the Tower transaction have been included in Susquehanna’s financial results since the acquisition date, February 17, 2012. Tower shareholders received, at their election, either 3.4696 shares of Susquehanna common stock, or $28.00 in cash, or some combination of shares and cash, for each share of Tower common stock held immediately prior to the effective time of the Tower merger, with $88.0 million of the aggregate merger consideration being paid in cash. A total of 30.8 million shares of Susquehanna common stock were issued in connection with the Tower merger.

The Tower transaction has been accounted for using the acquisition method of accounting and, accordingly, assets acquired, liabilities assumed and consideration transferred were recorded at estimated fair value on the acquisition date. Assets acquired totaled $2,388,122, including $1,975,488 of loans and leases (including $854,993 of commercial real estate loans, $136,979 of commercial loans and leases, and $758,803 of residential real estate loans). Liabilities assumed aggregated $2,255,413, including $2,074,372 of deposits. The transaction added $302,112 to the Susquehanna shareholders’ equity. Goodwill of $257,408, was recorded as a result of the transaction, including an adjustment of $10,547 for provisional amounts included in the previously estimated purchase price allocation.

The consideration transferred for Tower’s common equity and the amounts of acquired identifiable assets and liabilities assumed as of the acquisition date were as follows:

			February 17,
			2012
Purchase price:
	Value of:
	Common shares issued and options assumed		$	302,112
	Cash			88,005
		Total purchase price		390,117
Identifiable assets:
	Cash and due from banks			85,518
	Unrestricted short-term investments			9,171
	Securities available for sale			137,254
	Loans and leases			1,975,488
	Intangible assets			27,334
	Other assets			153,357
		Total identifiable assets		2,388,122
Identifiable liabilities:
	Deposits			2,074,372
	Short-term borrowings			10,228
	Long-term borrowings			103,923
	Other liabilities			66,890
		Total liabilities		2,255,413
Net goodwill resulting from acquisition			$	257,408

In many cases, determining the fair value of the purchased assets and assumed liabilities required Susquehanna to estimate cash flows expected to result from those assets and liabilities and to discount those cash flows at appropriate rates of interest. The most significant of these determinations related to the valuation of purchased loans.

The following is a summary of the loans purchased in the Tower transaction:
			Purchased		Purchased
			Credit		Non-		Total
			Impaired		Impaired		Purchased
			Loans		Loans		Loans
	Contractually required principal and interest at
		acquisition	$	348,889	$	2,376,071	$	2,724,960
	Contractual cash flows not expected to be collected			(127,318)		(135,736)		(263,054)
	Expected cash flows at acquisition			221,571		2,240,335		2,461,906
	Interest component of expected cash flows			(54,418)		(432,000)		(486,418)
	Basis in acquired loans at acquisition - estimated fair
		value	$	167,153	$	1,808,335	$	1,975,488

9

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

The core deposit intangible of $24,005 is being amortized using an accelerated method over a period of 10 years based upon the estimated economic benefits received.

The fair value of checking, savings and money market deposit accounts acquired from Tower was assumed to be approximately the carrying value as these accounts have no stated maturity and are payable on demand. Certificate of deposit accounts were valued as the present value of the certificates’ expected contractual payments discounted at market rates for similar certificates.

In connection with the Tower acquisition, Susquehanna incurred merger-related expenses related to personnel, occupancy and equipment, and other costs of integrating and conforming acquired operations with and into Susquehanna. Those expenses consisted largely of costs related to professional services, conversion of systems and/or integration of operations, and termination of existing contractual arrangements of Tower to purchase various services; initial marketing and promotion expenses designed to introduce Susquehanna to its new customers; travel costs; and printing, postage, supplies, and other costs of completing the transaction and commencing operations in new markets and offices. A summary of merger-related expenses included in the consolidated statement of income follows:

	There were no merger-related expenses incurred during the three and nine month periods ending September 30, 2013.
		Three Months Ended September 30, 2012						Nine Months Ended September 30, 2012
		Abington		Tower		Total		Abington		Tower		Total
Salaries and employee benefits		$	2	$	489	$	491	$	2	$	3,544	$	3,546
Consulting			2		403		405		68		4,546		4,614
Legal			193		152		345		372		1,471		1,843
Branch writeoffs			0		0		0		0		1,371		1,371
Net occupancy and equipment			0		0		0		0		2,840		2,840
All other			170		89		259		805		1,278		2,083
		$	367	$	1,133	$	1,500	$	1,247	$	15,050	$	16,297

Pro Forma Condensed Combined Financial Information

If the Tower acquisition had been completed on January 1, 2012, total revenue, net of interest expense, would have been approximately $573.8 million for the nine months ended September 30, 2012, and net income from continuing operations would have been approximately $98.1 million for the same period.

Pro forma results of operations do not include the impact of conforming certain acquiree accounting policies to Susquehanna’s policies. The pro forma financial information does not indicate the impact of possible business model changes nor does it consider any potential impacts of current market conditions or revenues, expense efficiencies, or other factors.

10

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

NOTE 3. Investment Securities

The amortized cost and fair values of investment securities at September 30, 2013 and December 31, 2012 were as follows:

				Gross		Gross
		Amortized		Unrealized		Unrealized		Fair
At September 30, 2013		Cost		Gains		Losses		Value
Available-for-Sale:
	U.S. Government agencies	$	85,149	$	523	$	479	$	85,193
	Obligations of states and political subdivisions		390,752		14,356		3,830		401,278
	Agency residential mortgage-backed securities		1,879,504		18,135		12,829		1,884,810
	Non-agency residential mortgage-backed securities		24,106		70		580		23,596
	Commercial mortgage-backed securities		10,173		319		0		10,492
	Other structured financial products		25,049		0		13,605		11,444
	Other debt securities		43,135		323		629		42,829
			2,457,868		33,726		31,952		2,459,642
	Other equity securities		24,199		439		905		23,733
Total available-for-sale securities		$	2,482,067	$	34,165	$	32,857	$	2,483,375
				Gross		Gross
		Amortized		Unrealized		Unrealized		Fair
At December 31, 2012		Cost		Gains		Losses		Value
Available-for-Sale:
	U.S. Government agencies	$	113,367	$	1,041	$	0	$	114,408
	Obligations of states and political subdivisions		403,487		32,585		295		435,777
	Agency residential mortgage-backed securities		1,843,511		37,104		53		1,880,562
	Non-agency residential mortgage-backed securities		29,428		2		1,980		27,450
	Commercial mortgage-backed securities		38,847		1,533		0		40,380
	Other structured financial products		25,011		0		15,461		9,550
	Other debt securities		43,076		2,643		464		45,255
			2,496,727		74,908		18,253		2,553,382
	Other equity securities		24,097		1,179		757		24,519
Total available-for-sale securities		$	2,520,824	$	76,087	$	19,010	$	2,577,901

At September 30, 2013 and December 31, 2012, investment securities with carrying values of $1,613,774 and $1,775,345, respectively, were pledged to secure public funds and for other purposes as required by law.

The amortized cost and fair value of U.S. Government agencies, obligations of states and political subdivisions, agency and non-agency residential mortgage-backed securities, commercial mortgage-backed securities, other structured financial products, other debt securities, and residential and commercial mortgage-backed securities, at September 30, 2013 and December 31, 2012, by contractual maturity, are shown below. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

11

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

			September 30, 2013				December 31, 2012
			Amortized		Fair		Amortized		Fair
			Cost		Value		Cost		Value
Securities available for sale:
	Within one year		$	6,068	$	6,230	$	8,690	$	8,781
	After one year but within five years			105,652		106,773		141,362		143,714
	After five years but within ten years			970,915		975,745		935,796		952,680
	After ten years			1,375,233		1,370,894		1,410,879		1,448,207
		Total	$	2,457,868	$	2,459,642	$	2,496,727	$	2,553,382

Gross realized gains and gross realized losses on investment securities transactions are summarized below. These gains and losses were recognized using the specific identification method and were included in noninterest income.

	Available-for-sale Securities
	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
Gross gains	$	2	$	278	$	435	$	5,018
Gross losses		0		(247)		(1)		(3,241)
Other-than-temporary impairment		0		0		(485)		(144)
Net gains	$	2	$	31	$	(51)	$	1,633

The following table presents Susquehanna’s investments’ gross unrealized losses and the corresponding fair values by investment category and length of time that the securities have been in a continuous unrealized loss position, at September 30, 2013 and December 31, 2012.

September 30, 2013	Less than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
U.S. Government agencies	$	42,946	$	479	$	0	$	0	$	42,946	$	479
Obligations of states and political subdivisions		74,465		3,658		7,048		172		81,513		3,830
Agency residential mortgage-backed securities		872,355		12,829		0		0		872,355		12,829
Non-agency residential mortgage-backed securities		535		4		13,177		576		13,712		580
Other structured financial products		0		0		11,444		13,605		11,444		13,605
Other debt securities		18,576		173		6,565		456		25,141		629
Other equity securities		0		0		1,610		905		1,610		905
	$	1,008,877	$	17,143	$	39,844	$	15,714	$	1,048,721	$	32,857
December 31, 2012	Less than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
Obligations of states and political subdivisions		31,791		295		0		0		31,791		295
Agency residential mortgage-backed securities		11,291		53		0		0		11,291		53
Non-agency residential mortgage-backed securities		12,117		450		14,683		1,530		26,800		1,980
Other structured financial products		0		0		9,551		15,461		9,551		15,461
Other debt securities		0		0		6,518		464		6,518		464
Other equity securities		1,751		585		796		172		2,547		757
	$	56,950	$	1,383	$	31,548	$	17,627	$	88,498	$	19,010

Non-agency residential mortgage-backed securities. At September 30, 2013, Susquehanna held three securities that had unrealized losses, of which two were rated below investment grade. None of Susquehanna’s non-agency residential mortgage-backed

12

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

securities were backed by loans identified by the issuer as subprime or Alt-A collateral. Management has analyzed the collateral underlying these securities with respect to defaults, loan to collateral value ratios, current levels of subordination, and geographic concentrations and concluded that there is no unrecognized other-than-temporarily impairment.

Susquehanna recorded other-than-temporary impairment losses as presented in the following table:

Credit Losses on Non-agency Residential Mortgage-backed and Other Equity Securities for which a Portion of an
Other-than-temporary Impairment was Recognized in Other Comprehensive Income
			Three Months Ended				Nine Months Ended
			September 30,				September 30,
			2013		2012		2013		2012
Balance - beginning of period			$	1,635	$	1,566	$	1,280	$	4,602
Additions:
	Amount related to credit losses for which an other-than-
		temporary impairment was not previously recognized		0		0		325		0
	Additional amount related to credit losses for which an other-than-
		temporary impairment was previously recognized		0		0		160		144
Deductions:
	Realized losses			26		0		156		0
	Sale of securities for which other-than-temporary impairment was
		previously recognized		0		0		0		3,180
Balance - end of period			$	1,609	$	1,566	$	1,609	$	1,566

Susquehanna estimated the portion of loss attributable to credit using a discounted cash flow model. Susquehanna, in conjunction with a third-party financial advisory firm, assisted with the development of key assumptions including the expected cash flows of the underlying collateral of the non-agency residential mortgage-backed securities using internal credit risk, interest rate risk, and prepayment risk models that incorporated management’s best estimate of current key assumptions, such as default rates, loss severity, and prepayment rates.  Assumptions used can vary widely from loan to loan and are influenced by such factors as loan interest rate, geographical location of the borrower, borrower characteristics, and collateral type. The distribution of underlying cash flows is determined in accordance with the security’s terms. Expected principal and interest cash flows on an other-than-temporarily impaired debt security are discounted using the effective yield of that debt security.

13

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

Based on the expected cash flows derived from the model, Susquehanna expects to recover the unrealized loss in accumulated other comprehensive income ($321 and $1,096 at September 30, 2013 and 2012, respectively). Significant assumptions used in the valuation of these other-than-temporarily impaired securities were as follows:

			Weighted-average (%)
			September 30,
			2013	2012
		Conditional repayment rate (1)	10.6%	7.4%
		Loss severity (2)	37.8%	45.0%
		Conditional default rate (3)	3.6%	4.7%
(1)	Conditional repayment rate represents a rate equal to the proportion of principal balance paid off voluntarily over a certain period of time on an annualized basis.
(2)	Loss severity rates are projected by considering collateral characteristics such as current loan-to-value, original creditworthiness of borrowers (FICO score) and geographic concentration.
(3)	Conditional default rate is an annualized rate of default on a group of mortgages, and represents the percentage of outstanding principal balances in the pool that are in default, which typically equates to the borrower being past due 60 days, 90 days, or possibly already in the foreclosure process.

Management provides input and monitors the third party valuation process of the non-agency residential mortgage-backed securities. A detailed review of the key assumptions and inputs is performed by Susquehanna’s Investment Officers and the results are reviewed by the Corporate Investment Committee (“CIC”) before being accepted and recorded. Key assumptions reviewed by the company include prepayment assumptions, default rates, loss severity, bond waterfall payments, and the discount rate as well as the actual performance of the underlying collateral. Additionally, available market indications of similar securities are provided by Susquehanna to the third party and are given a significant weighting by the third party.

Other structured financial products. Susquehanna’s structured financial product investments are comprised of four pooled trust preferred securities which have an aggregate unrealized loss of $13,605 and $16,577 at September 30, 2013 and 2012, respectively. All of these securities are below investment grade but are of a more senior tranche of the specific issue. Susquehanna has contracted with a third-party financial advisory firm (“third party firm”) to assist in its other-than-temporary impairment analysis of its structured financial product investments. Susquehanna’s Investment Officers have assisted with the development of, and performed a detailed review of the key assumptions. The review of the inputs for the valuation of the pooled trust preferred securities is performed by the CIC. Key aspects reviewed by CIC include the detail on non-performing financial institutions within the pools of trust preferred securities, the probability of default of the underlying institutions within the pools, the discount rate, trades of similar securities and indexes, and the weighting given to market indications. Susquehanna management believes that the valuation analysis and methodology reasonably supports the value and projected performance of the specific trust preferred securities. Management believes this valuation methodology presents an appropriate approach in the determination of other-than-temporary impairment charges in accordance with GAAP.

The third party firm uses a proprietary methodology to determine the other-than-temporary impairment of Susquehanna’s pooled trust preferred securities. Using publicly available financial information, the third party firm’s valuation analysis compares the present value of the expected base cash flows with the amortized cost basis of the trust preferred securities to determine whether Susquehanna expects to receive the entire amortized cost basis of such securities. To make this comparison, the third party firm evaluates two scenarios consisting of three phases each. The two scenarios are: (1) the first dollar loss scenario, and, (2) the expected or forecasted scenario. The three phases associated with each scenario are production of cash flows, application of the cash flows to the percent owned, and assessment of any other-than-temporary impairment.

To determine expected cash flows, the valuation analysis considers credit default rates, call options and deferrals, waterfall structure, and covenants relating to the trust preferred securities. The trust indenture documentation and the trustee reports for each specific trust preferred security issuance provides information regarding deferral rights, call options, various triggers, (including over-collateralization triggers), and waterfall structure, which management believes is essential in determining projected base cash flows. The third party firm determines short-term default risk using ratios, including the Texas ratio, that relate to the issuers, capitalization,

14

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

asset quality, profitability, and liquidity. To determine longer term default probabilities, the third party firm uses an internal scoring approach that relies on key historical financial performance ratios. Management believes that future cash flows for these securities are reasonably developed and supported.

If a collateral security is in default at the assessment date, a recovery rate specific to the issuer of the collateral security is incorporated into the expected cash flows with a twenty-four month lag in timing of receipt of those expected cash flows. The third party firm calculates a terminal default rate based upon certain key financial ratios of the active issuers in the security relative to all FDIC insured bank institutions. The active issuers of the collateral securities are summarized as a weighted average based on issue size according to status of deferral and default assumption. To enhance the analysis, the third party firm calculates the standard deviation across the issuers for each ratio and removes any issuer that falls more than three standard deviations above or below the average for that ratio. No recovery is incorporated into the expected cash flows for any issuers that exceed the terminal default rate. For issuers currently making interest payments and for those currently deferring interest payments, Susquehanna makes an estimate using publicly available financial information as to the likelihood and timing of any default, after which the estimated cash flow reflects a recovery rate specific to the issuer. Issuers of collateral securities that are currently deferring interest payments and not expected to default are assumed to continue to defer interest payments for twenty quarters, the full contractually permitted deferral, from the period of initial deferral.

In considering the amount and timing of expected cash flows on the pooled trust preferred securities, management considers the right of the issuers of the securities underlying the pooled trust preferred securities to call those collateral securities. Management assesses any projected exercise of the call option, incorporating changes in economic and market conditions and the impact of any change in timing of expected cash flows in the measurement of fair value and other-than-temporary impairment.

The discount rate applied to the projected cash flows for the specific class is calculated using a spread to the current swap curve. The swap curve gives a market participant perspective of the term structure of interest rates and on credit spreads. The determination of the discount rate used in Susquehanna’s valuation is based upon the referenced swap curve plus an additional credit spread based upon the credit rating of the class. Lower rated classes would have a wider implied credit spread. These multiple discount rates are then applied to the estimated cash flows in determining the estimated value.

15

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

	The present value of the expected cash flows for Susquehanna’s specific class and subordinate classes, as well as additional
information about the pooled trust preferred securities, are included in the following tables.
As of September 30, 2013		Pooled Trust #1		Pooled Trust #2		Pooled Trust #3		Pooled Trust #4
Book value (SUSQ)		$	3,000	$	7,183	$	8,116	$	6,750
Fair value			1,400		3,654		4,081		2,309
Unrealized loss			(1,600)		(3,529)		(4,035)		(4,441)
Class		B		B		B		A2L
Class face value		$	35,000	$	59,409	$	89,268	$	45,500
Present value of expected cash flows
	for class noted above and all
	subordinated classes (1)	$	172,482	$	194,406	$	305,868	$	153,932
Lowest credit rating assigned		D		Ca		Ca		Ca
Original collateral		$	623,984	$	501,470	$	700,535	$	487,680
Performing collateral			393,342		299,934		472,261		273,488
Actual defaults			41,600		51,580		44,000		75,357
Actual deferrals			34,300		98,310		93,650		93,080
Projected future defaults			41,274		45,777		49,510		42,236
Actual defaults as a % of original
	collateral		6.7%		10.3%		6.3%		15.5%
Actual deferrals as a % of original
	collateral (2)		5.5%		19.6%		13.4%		19.1%
Actual defaults and deferrals as a % of
	original collateral		12.2%		29.9%		19.7%		34.6%
Projected future defaults as a % of
	original collateral (3)		6.6%		9.1%		7.1%		8.7%
Actual institutions deferring and
	defaulted as a % of total institutions		16.9%		34.5%		24.6%		40.9%
Projected future defaults as a % of
	performing collateral plus
	deferrals		9.7%		11.5%		8.7%		11.5%

16

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

As of September 30, 2012		Pooled Trust #1		Pooled Trust #2		Pooled Trust #3		Pooled Trust #4
Book value (SUSQ)		$	3,000	$	7,142	$	8,078	$	6,750
Fair value			775		2,609		2,927		2,082
Unrealized loss			(2,225)		(4,533)		(5,151)		(4,668)
Class		B		B		B		A2L
Class face value		$	35,000	$	58,745	$	88,449	$	45,500
Present value of expected cash flows
	for class noted above and all
	subordinated classes (1)	$	142,581	$	166,849	$	262,974	$	139,918
Lowest credit rating assigned		Ca		Ca		Ca		Ca
Original collateral		$	623,984	$	501,470	$	700,535	$	487,680
Performing collateral			352,028		293,200		462,731		304,600
Actual defaults			10,000		51,580		44,000		75,446
Actual deferrals			107,400		127,690		138,150		83,081
Projected future defaults			80,793		60,801		68,916		47,451
Actual defaults as a % of original
	collateral		1.6%		10.3%		6.3%		15.5%
Actual deferrals as a % of original
	collateral (2)		17.2%		25.5%		19.7%		17.0%
Actual defaults and deferrals as a % of
	original collateral		18.8%		35.8%		26.0%		32.5%
Projected future defaults as a % of
	original collateral (3)		12.9%		12.1%		9.8%		9.7%
Actual institutions deferring and
	defaulted as a % of total institutions		19.7%		39.3%		34.4%		38.2%
Projected future defaults as a % of
	performing collateral plus
	deferrals		17.6%		14.4%		11.5%		12.2%
(1)	Susquehanna determines whether it expects to recover the entire amortized cost basis by comparing the present value of the expected cash flows to be collected with the amortized cost basis. As of September 30, 2013 and 2012, the present value of the current estimated cash flows is equal to or greater than the book value of the trust preferred securities held. Consequently, there is no credit-related other-than-temporary impairment required to be recognized.
(2)	Includes current interest deferrals for the quarter for those institutions deferring as of the date of the assessment of the other-than-temporary impairment. Current deferrals are assumed to continue for twenty quarters, the full contractually permitted deferral period, if the institutions are not projected to default prior to that time.
(3)	Includes those institutions that are performing but are not projected to continue to perform and includes those institutions that are currently deferring interest that are projected to default, based upon third-party proprietary valuation methodology used to determine future defaults. Creditworthiness of each underlying issue in the collateralized debt obligation is determined using publicly available data.

17

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

NOTE 4. Loans and Leases

Originated loans and leases is defined to exclude loans purchased in business combinations since September 30, 2011, and purchased loans and leases is defined to include those loans and leases excluded from the definition of originated loans.

Loans and Leases, Net of Deferred Costs and Fees
				September 30,		December 31,
				2013		2012
	Commercial, financial, and agricultural			$	2,273,735	$	2,273,611
	Real estate - construction				765,246		847,781
	Real estate secured - residential				4,145,522		4,065,818
	Real estate secured - commercial				4,109,329		3,964,608
	Consumer				935,117		842,552
	Leases				1,147,505		900,371
			Total loans and leases	$	13,376,454	$	12,894,741
	Originated loans and leases			$	11,622,463	$	10,765,458
	Purchased loans and leases				1,753,991		2,129,283
			Total loans and leases	$	13,376,454	$	12,894,741
	Nonaccrual loans and leases			$	101,976	$	97,767
	Loans and leases contractually past due 90 days
		and still accruing			8,655		8,209
	Troubled debt restructurings				69,975		67,775
	Deferred origination costs, net of fees				20,278		17,763
	All overdrawn deposit accounts, reclassified
		as loans and evaluated for collectability			2,550		15,422

	A summary of our net investment in direct lease financing is presented below.
Net Investment in Direct Financing Leases
				September 30,		December 31,
				2013		2012
		Minimum lease payments receivable		$	661,239	$	568,110
		Estimated residual value of leases			567,562		409,753
		Unearned income under lease contracts			(81,296)		(77,492)
			Total leases	$	1,147,505	$	900,371

Susquehanna monitors the credit quality of its commercial loan portfolio using internal risk ratings. These risk ratings are consistent with established regulatory guidance. Loans with a Pass rating represent those not considered a problem credit. Special mention loans are those that have a potential weakness deserving management’s careful attention. Substandard loans are those where a well-defined weakness has been identified that may put the complete receipt of contractual cash flows at risk. Substandard loans are placed in nonaccrual status when Susquehanna believes it is no longer probable it will collect all contractual cash flows.

Susquehanna reviews the loan gradings on an annual basis or more frequently at any time management becomes aware of the potential for not collecting all contractual cash flows. Significant credits with ratings of special mention or substandard, and associated with a relationship greater than $1.0 million, are reviewed quarterly by the Loan Review committee.

Susquehanna monitors the credit quality of its retail loan portfolio based primarily on delinquency status, which is the primary factor considered in determining whether a retail loan should be classified as nonaccrual.

18

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

	The following tables present Susquehanna's credit quality indicators by internally assigned grading and by payment activity at
September 30, 2013 and December 31, 2012.
Credit Quality Indicators, at September 30, 2013
	Commercial Credit Exposure
		Credit-risk Profile by Internally Assigned Grade
								Real Estate -		Total
						Real Estate -		Secured -		Commercial
				Commercial		Construction (1)		Commercial (2)		Credit Exposure
Originated loans and leases
	Grade:
		Pass (3)		$	2,001,420	$	465,210	$	3,531,675	$	5,998,305
		Special mention (4)			88,046		52,792		193,867		334,705
		Substandard (5)			60,064		39,539		244,560		344,163
			Total	$	2,149,530	$	557,541	$	3,970,102	$	6,677,173
Purchased loans and leases
	Grade:
		Pass (3)		$	106,548	$	44,943	$	795,850	$	947,341
		Special mention (4)			4,745		8,222		77,812		90,779
		Substandard (5)			12,912		37,051		133,582		183,545
			Total	$	124,205	$	90,216	$	1,007,244	$	1,221,665
Total loans and leases
	Grade:
		Pass (3)		$	2,107,968	$	510,153	$	4,327,525	$	6,945,646
		Special mention (4)			92,791		61,014		271,679		425,484
		Substandard (5)			72,976		76,590		378,142		527,708
			Total	$	2,273,735	$	647,757	$	4,977,346	$	7,898,838
	Other Credit Exposure
		Credit-risk Profile based on Payment Activity
				Real Estate -
				Secured -						Total Other
				Residential		Consumer		Leases		Credit Exposure
Originated loans and leases
	Performing			$	2,849,108	$	927,206	$	1,145,870	$	4,922,184
	Nonperforming (6)				20,848		623		1,635		23,106
		Total		$	2,869,956	$	927,829	$	1,147,505	$	4,945,290
Purchased loans and leases
	Performing			$	514,944	$	7,275	$	0	$	522,219
	Nonperforming (6)				10,094		13		0		10,107
		Total		$	525,038	$	7,288	$	0	$	532,326
Total loans and leases
	Performing			$	3,364,052	$	934,481	$	1,145,870	$	5,444,403
	Nonperforming (6)				30,942		636		1,635		33,213
		Total		$	3,394,994	$	935,117	$	1,147,505	$	5,477,616

19

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

Credit Quality Indicators, at December 31, 2012
	Commercial Credit Exposure
		Credit-risk Profile by Internally Assigned Grade
								Real Estate -		Total
						Real Estate -		Secured -		Commercial
				Commercial		Construction (1)		Commercial (2)		Credit Exposure
Originated loans and leases
	Grade:
		Pass (3)		$	2,008,548	$	439,296	$	3,388,337	$	5,836,181
		Special mention (4)			45,733		76,852		141,817		264,402
		Substandard (5)			60,123		45,102		213,776		319,001
			Total	$	2,114,404	$	561,250	$	3,743,930	$	6,419,584
Purchased loans and leases
	Grade:
		Pass (3)		$	135,308	$	95,289	$	918,119	$	1,148,716
		Special mention (4)			7,685		34,519		82,021		124,225
		Substandard (5)			16,214		54,162		143,629		214,005
			Total	$	159,207	$	183,970	$	1,143,769	$	1,486,946
Total loans and leases
	Grade:
		Pass (3)		$	2,143,856	$	534,585	$	4,306,456	$	6,984,897
		Special mention (4)			53,418		111,371		223,838		388,627
		Substandard (5)			76,337		99,264		357,405		533,006
			Total	$	2,273,611	$	745,220	$	4,887,699	$	7,906,530
	Other Credit Exposure
		Credit-risk Profile based on Payment Activity
				Real Estate -
				Secured -						Total Other
				Residential		Consumer		Leases		Credit Exposure
Originated loans and leases
	Performing			$	2,591,349	$	830,495	$	898,781	$	4,320,625
	Nonperforming (6)				23,082		577		1,590		25,249
		Total		$	2,614,431	$	831,072	$	900,371	$	4,345,874
Purchased loans and leases
	Performing			$	618,796	$	11,469	$	0	$	630,265
	Nonperforming (6)				12,061		11		0		12,072
		Total		$	630,857	$	11,480	$	0	$	642,337
Total loans and leases
	Performing			$	3,210,145	$	841,964	$	898,781	$	4,950,890
	Nonperforming (6)				35,143		588		1,590		37,321
		Total		$	3,245,288	$	842,552	$	900,371	$	4,988,211
(1)	Includes only construction loans granted to commercial customers. Construction loans for individuals are included in Real Estate – Secured – Residential, below.
(2)	Includes loans obtained for commercial purposes that are also secured by residential real estate.
(3)	Includes loans identified as having acceptable risk, which are loans for which the possibility of loss is considered unlikely.
(4)	Includes loans considered potentially weak; however, no loss of principal or interest is anticipated.
(5)	Includes loans that are inadequately protected by the current net-worth and paying capacity of the borrower or by the collateral pledged, if any. Loss of principal or interest is considered reasonably possible or likely.
(6)	Includes loans that are on non-accrual status or past due ninety days or more.

20

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

	The following tables detail the age analysis of Susquehanna's past due financing receivables as of September 30, 2013 and December 31, 2012.
Age Analysis of Past Due Financing Receivables, as of September 30, 2013
	Financing Receivables that are Accruing
												Total
		30-59 Days		60-89 Days		90 Days		Total				Financing
		Past Due		Past Due		and Greater		Past Due		Current		Receivables
Commercial		$	2,759	$	1,428	$	224	$	4,411	$	2,259,276	$	2,263,687
Real estate - construction			1,150		1,438		722		3,310		745,439		748,749
Real estate secured - residential			9,095		6,171		5,272		20,538		4,097,106		4,117,644
Real estate secured - commercial			3,879		5,444		1,824		11,147		4,052,276		4,063,423
Consumer			5,814		1,387		448		7,649		927,291		934,940
Leases			1,034		197		165		1,396		1,144,639		1,146,035
	Total	$	23,731	$	16,065	$	8,655	$	48,451	$	13,226,027	$	13,274,478
Originated loans and leases		$	20,599	$	13,007	$	7,347	$	40,953	$	11,495,358	$	11,536,311
Purchased loans and leases			3,132		3,058		1,308		7,498		1,730,669		1,738,167
	Total	$	23,731	$	16,065	$	8,655	$	48,451	$	13,226,027	$	13,274,478
	Financing Receivables that are Nonaccruing
												Total
		30-59 Days		60-89 Days		90 Days		Total				Financing
		Past Due		Past Due		and Greater		Past Due		Current		Receivables
Commercial		$	7	$	354	$	5,644	$	6,005	$	4,043	$	10,048
Real estate - construction			794		390		14,498		15,682		815		16,497
Real estate secured - residential			188		977		16,805		17,970		9,908		27,878
Real estate secured - commercial			3,311		2,827		23,874		30,012		15,894		45,906
Consumer			0		89		50		139		38		177
Leases			0		115		179		294		1,176		1,470
	Total	$	4,300	$	4,752	$	61,050	$	70,102	$	31,874	$	101,976
Originated loans and leases		$	2,501	$	3,802	$	54,801	$	61,104	$	25,048	$	86,152
Purchased loans and leases			1,799		950		6,249		8,998		6,826		15,824
	Total	$	4,300	$	4,752	$	61,050	$	70,102	$	31,874	$	101,976

21

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

Age Analysis of Past Due Financing Receivables, as of December 31, 2012
	Financing Receivables that are Accruing
												Total
		30-59 Days		60-89 Days		90 Days		Total				Financing
		Past Due		Past Due		and Greater		Past Due		Current		Receivables
Commercial		$	5,163	$	762	$	359	$	6,284	$	2,256,863	$	2,263,147
Real estate - construction			8,568		1,614		157		10,339		822,625		832,964
Real estate secured - residential			19,544		4,467		5,547		29,558		4,007,820		4,037,378
Real estate secured - commercial			9,623		13,746		1,394		24,763		3,897,224		3,921,987
Consumer			8,898		1,678		545		11,121		831,388		842,509
Leases			5,445		487		207		6,139		892,850		898,989
	Total	$	57,241	$	22,754	$	8,209	$	88,204	$	12,708,770	$	12,796,974
Originated loans and leases		$	51,679	$	21,471	$	5,720	$	78,870	$	10,596,166	$	10,675,036
Purchased loans and leases			5,562		1,283		2,489		9,334		2,112,604		2,121,938
	Total	$	57,241	$	22,754	$	8,209	$	88,204	$	12,708,770	$	12,796,974
	Financing Receivables that are Nonaccruing
												Total
		30-59 Days		60-89 Days		90 Days		Total				Financing
		Past Due		Past Due		and Greater		Past Due		Current		Receivables
Commercial		$	631	$	649	$	6,068	$	7,348	$	3,116	$	10,464
Real estate - construction			0		405		14,047		14,452		365		14,817
Real estate secured - residential			953		452		19,551		20,956		7,484		28,440
Real estate secured - commercial			2,483		622		30,433		33,538		9,083		42,621
Consumer			0		0		0		0		43		43
Leases			0		656		408		1,064		318		1,382
	Total	$	4,067	$	2,784	$	70,507	$	77,358	$	20,409	$	97,767
Originated loans and leases		$	4,067	$	2,379	$	65,830	$	72,276	$	18,146	$	90,422
Purchased loans and leases			0		405		4,677		5,082		2,263		7,345
	Total	$	4,067	$	2,784	$	70,507	$	77,358	$	20,409	$	97,767

22

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

The following tables provide information about Susquehanna’s impaired loans, including principal balance, recorded investment, and related specific allowance amounts at the dates indicated. Loans with no specific allowance for loan losses have adequate collateral securing their carrying value and in some circumstances have been charged down to their current carrying value based on the fair value of the collateral less selling costs.

Impaired Loans at September 30, 2013
													Average
						Recorded							Recorded
				Unpaid		Investment							Investment		Interest
				Principal		in Impaired			Related		Related		in Impaired		Income
				Balance		Loans			Charge-offs		Allowance		Loans (2)		Recognized
Impaired loans without a related reserve:
	Commercial, financial, and agricultural			$	21,189	$	21,034		$	155			$	21,385	$	281
	Real estate - construction				36,542		20,800			15,742				20,686		60
	Real estate secured - residential				33,099		30,296			2,803				31,130		425
	Real estate secured - commercial				113,829		103,090			10,739				101,660		1,466
	Consumer				254		254			0				254		3
		Total impaired loans without a
			related reserve		204,913		175,474	(1)		29,439				175,115		2,235
Impaired loans with a related reserve:
	Commercial, financial, and agricultural				7,724		7,402			322	$	3,129		7,580		152
	Real estate - construction				11,542		5,426			6,116		2,105		7,873		238
	Real estate secured - residential				33,988		32,887			1,101		2,614		32,878		491
	Real estate secured - commercial				52,554		41,499			11,055		7,406		38,611		514
	Consumer				1,740		1,740			0		51		1,779		38
		Total impaired loans with a
			related reserve		107,548		88,954			18,594		15,305		88,721		1,433
Total impaired loans:
	Commercial, financial, and agricultural				28,913		28,436			477		3,129		28,965		433
	Real estate - construction				48,084		26,226			21,858		2,105		28,559		298
	Real estate secured - residential				67,087		63,183			3,904		2,614		64,008		916
	Real estate secured - commercial				166,383		144,589			21,794		7,406		140,271		1,980
	Consumer				1,994		1,994			0		51		2,033		41
			Total impaired loans	$	312,461	$	264,428		$	48,033	$	15,305	$	263,836	$	3,668
Impaired loans without a related reserve:
	Originated loans and leases			$	78,752	$	50,273		$	28,479			$	48,835	$	494
	Purchased loans and leases				126,161		125,201			960				126,280		1,741
		Total impaired loans without a
			related reserve		204,913		175,474			29,439				175,115		2,235
Impaired loans with a related reserve:
	Originated loans and leases				94,063		75,652			18,411	$	11,718		74,879		1,167
	Purchased loans and leases				13,485		13,302			183		3,587		13,842		266
		Total impaired loans with a
			related reserve		107,548		88,954			18,594		15,305		88,721		1,433
Total impaired loans:
	Originated loans and leases				172,815		125,925			46,890		11,718		123,714		1,661
	Purchased loans and leases (3)				139,646		138,503			1,143		3,587		140,122		2,007
			Total impaired loans	$	312,461	$	264,428		$	48,033	$	15,305	$	263,836	$	3,668
(1)	$28,703 of the $175,474 total impaired loans without a related reserve represents loans that had been written down to the fair value of the underlying collateral adjusted for selling costs through direct charge-offs of $29,439.
(2)	Average recorded investment in impaired loans is calculated on a quarterly basis using daily balances.
(3)	$13,302 of the $138,503 purchased impaired loans were subsequently impaired after being acquired.

23

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

Impaired Loans at December 31, 2012
													Average
						Recorded							Recorded
				Unpaid		Investment							Investment		Interest
				Principal		in Impaired			Related		Related		in Impaired		Income
				Balance		Loans			Charge-offs		Allowance		Loans (2)		Recognized
Impaired loans without a related reserve:
	Commercial, financial, and agricultural			$	23,959	$	23,877		$	82			$	24,603	$	233
	Real estate - construction				48,394		32,717			15,677				34,223		882
	Real estate secured - residential				26,298		25,261			1,037				25,417		398
	Real estate secured - commercial				133,903		119,217			14,686				118,424		1,727
	Consumer				114		114			0				114		3
		Total impaired loans without a
			related reserve		232,668		201,186	(1)		31,482				202,781		3,243
Impaired loans with a related reserve:
	Commercial, financial, and agricultural				4,240		4,184			56	$	3,267		4,278		47
	Real estate - construction				12,894		5,577			7,317		952		5,883		237
	Real estate secured - residential				32,640		32,375			265		6,633		32,498		333
	Real estate secured - commercial				49,322		39,331			9,991		4,884		40,778		486
	Consumer				0		0			0		0		0		0
		Total impaired loans with a
			related reserve		99,096		81,467			17,629		15,736		83,437		1,103
Total impaired loans:
	Commercial, financial, and agricultural				28,199		28,061			138		3,267		28,881		280
	Real estate - construction				61,288		38,294			22,994		952		40,106		1,119
	Real estate secured - residential				58,938		57,636			1,302		6,633		57,915		731
	Real estate secured - commercial				183,225		158,548			24,677		4,884		159,202		2,213
	Consumer				114		114			0		0		114		3
			Total impaired loans	$	331,764	$	282,653		$	49,111	$	15,736	$	286,218	$	4,346
Impaired loans without a related reserve:
	Originated loans and leases			$	76,120	$	45,560		$	30,560			$	49,975	$	764
	Purchased loans and leases				156,548		155,626			922				152,806		2,479
		Total impaired loans without a
			related reserve		232,668		201,186			31,482				202,781		3,243
Impaired loans with a related reserve:
	Originated loans and leases				92,471		74,842			17,629	$	14,649		76,823		1,033
	Purchased loans and leases				6,625		6,625			0		1,087		6,614		70
		Total impaired loans with a
			related reserve		99,096		81,467			17,629		15,736		83,437		1,103
Total impaired loans:
	Originated loans and leases				168,591		120,402			48,189		14,649		126,798		1,797
	Purchased loans and leases (3)				163,173		162,251			922		1,087		159,420		2,549
			Total impaired loans	$	331,764	$	282,653		$	49,111	$	15,736	$	286,218	$	4,346
(1)	$28,658 of the $201,186 total impaired loans without a related reserve represents loans that had been written down to the fair value of the underlying collateral adjusted for selling costs through direct charge-offs of $31,482.
(2)	Average recorded investment in impaired loans is calculated on a quarterly basis using daily balances.
(3)	$6,625 of the $162,251 purchased impaired loans were subsequently impaired after being acquired.

24

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

	The following table presents Troubled Debt Restructurings (TDR's), by class segment:
				September 30,		December 31,
				2013		2012
		Commercial, financial, and agricultural		$	9,609	$	8,744
		Real estate - construction			331		940
		Real estate secured - residential			26,848		23,224
		Real estate secured - commercial			31,766		33,589
		Consumer			1,421		1,278
			Total performing TDRs		69,975		67,775
		Non-performing TDRs (1)			22,166		24,603
			Total TDRs	$	92,141	$	92,378
		Performing TDRs			76%		73%
		Non-performing TDRs			24%		27%
(1)	These loans are included in the 90 day past due and non-accrual categories.

	The following table provides detail of TDR balance and activity for the periods presented:
		Three months ended				Nine months ended
		September 30,				September 30,
		2013		2012		2013		2012
Performing TDRs, beginning of period		$	63,822	$	66,777	$	67,775	$	72,852
	New TDR Status		13,336		7,635		38,405		12,958
	Paydowns		(830)		(992)		(4,080)		(7,805)
	Charge-offs post modification		(9)		(112)		(6,734)		(623)
	Transfer to nonaccrual, past due 90 days or greater		(5,407)		(614)		(11,449)		(4,822)
	Cured		(938)		(15,786)		(13,551)		(15,652)
	Other, net (1)		1		(85)		(391)		(85)
Performing TDRs, end of period		$	69,975	$	56,823	$	69,975	$	56,823
Non-performing TDRs (2), end of period		$	22,166	$	17,895	$	22,166	$	17,895
Performing TDRs			76%		76%		76%		76%
Non-performing TDRs			24%		24%		24%		24%
(1)	Includes $203 transferred to OREO in 2013.
(2)	Included in Age Analysis of Past Due Financing Receivables.

25

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

The following tables summarize Susquehanna’s loan modification activities that were considered troubled debt restructurings for the three and nine month periods ended September 30, 2013 and 2012.

			Recorded Investment
								Financial Effect of
				Pre-Modification		Post-Modification		Modification
			Number of	Recorded		Recorded		Recorded
Three months ended September 30, 2013			Loans	Investment		Investment		Investment(1)		Interest (2)
Troubled Debt Restructurings
	Commercial, financial, and agricultural
		Other (3)	6	$	845	$	845	$	0	$	(6)
		Combination of modification types	1		51		51		0		0
	Real estate - construction
		Other (3)	0		0		0		0		0
		Combination of modification types	0		0		0		0		0
	Real estate secured - residential
		Other (3)	37		3,715		3,715		0		0
		Combination of modification types	8		1,313		1,313		0		51
	Real estate secured - commercial
		Other (3)	7		7,066		7,066		0		0
		Combination of modification types	0		0		0		0		0
	Consumer
		Other (3)	42		320		320		0		0
		Combination of modification types	1		26		26		0		0
	Total		102	$	13,336	$	13,336	$	0	$	45
Originated loans and leases			99	$	12,962	$	12,962	$	0	$	66
Purchased loans and leases			3		374		374		0		(21)
	Total		102	$	13,336	$	13,336	$	0	$	45
(1)	Financial effects impacting the recorded investment include principal payments, advances, charge-offs, and capitalized past-due amounts.
(2)	Represents the present value of interest rate concessions discounted at the effective rate of the original loan.
(3)	Bankruptcies and maturity date extensions.
					Number of	Recorded
					Loans	Investment
Troubled Debt Restructurings that Subsequently
	Defaulted during the current period
		Commercial, financial, and agricultural			3	$	33
		Real estate - construction			1		117
		Real estate secured - residential			17		862
		Real estate secured - commercial			4		4,640
		Consumer			31		263
		Total			56	$	5,915
Originated loans and leases					53	$	5,849
Purchased loans and leases					3		66
		Total			56	$	5,915

26

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

			Recorded Investment
								Financial Effect of
				Pre-Modification		Post-Modification		Modification
			Number of	Recorded		Recorded		Recorded
Three months ended September 30, 2012			Loans	Investment		Investment		Investment(1)		Interest (2)
Troubled Debt Restructurings
	Commercial, financial, and agricultural
		Other (3)	6	$	457	$	457	$	0	$	0
		Combination of modification types	0		0		0		0		0
	Real estate - construction
		Other (3)	2		343		343		0		0
		Combination of modification types	0		0		0		0		0
	Real estate secured - residential
		Other (3)	57		4,766		4,766		0		0
		Combination of modification types	3		230		230		0		0
	Real estate secured - commercial
		Other (3)	6		1,539		1,539		0		0
		Combination of modification types	0		0		0		0		0
	Consumer
		Other (3)	35		300		300		0		0
		Combination of modification types	0		0		0		0		0
	Total		109	$	7,635	$	7,635	$	0	$	0
Originated loans and leases			87	$	5,370	$	5,370	$	0	$	0
Purchased loans and leases			22		2,265		2,265		0		0
	Total		109	$	7,635	$	7,635	$	0	$	0
(1)	Financial effects impacting the recorded investment include principal payments, advances, charge-offs, and capitalized past-due amounts.
(2)	Represents the present value of interest rate concessions discounted at the effective rate of the original loan.
(3)	Bankruptcies and maturity date extensions.
					Number of	Recorded
					Loans	Investment
Troubled Debt Restructurings that Subsequently
	Defaulted during the current period
		Commercial, financial, and agricultural			1	$	351
		Real estate - construction			0		0
		Real estate secured - residential			4		641
		Real estate secured - commercial			1		199
		Consumer			0		0
		Total			6	$	1,191
Originated loans and leases					5	$	817
Purchased loans and leases					1		374
		Total			6	$	1,191

27

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

			Recorded Investment
								Financial Effect of
				Pre-Modification		Post-Modification		Modification
			Number of	Recorded		Recorded		Recorded
Nine months ended September 30, 2013			Loans	Investment		Investment		Investment(1)		Interest (2)
Troubled Debt Restructurings
	Commercial, financial, and agricultural
		Other (3)	29	$	9,379	$	9,379	$	0	$	(6)
		Combination of modification types	2		292		292		0		0
	Real estate - construction
		Other (3)	2		137		137		0		0
		Combination of modification types	0		0		0		0		0
	Real estate secured - residential
		Other (3)	136		12,038		12,038		0		0
		Combination of modification types	25		3,815		3,815		0		(21)
	Real estate secured - commercial
		Other (3)	19		9,565		9,565		0		0
		Combination of modification types	1		1,436		1,436		0		(196)
	Consumer
		Other (3)	192		1,717		1,717		0		0
		Combination of modification types	1		26		26		0		0
	Total		407	$	38,405	$	38,405	$	0	$	(223)
Originated loans and leases			386	$	35,569	$	35,569	$	0	$	(159)
Purchased loans and leases			21		2,836		2,836		0		(64)
	Total		407	$	38,405	$	38,405	$	0	$	(223)
(1)	Financial effects impacting the recorded investment include principal payments, advances, charge-offs, and capitalized past-due amounts.
(2)	Represents the present value of interest rate concessions discounted at the effective rate of the original loan.
(3)	Bankruptcies and maturity date extensions.
					Number of	Recorded
					Loans	Investment
Troubled Debt Restructurings that Subsequently
	Defaulted during the current period
		Commercial, financial, and agricultural			15	$	7,334
		Real estate - construction			3		254
		Real estate secured - residential			30		2,152
		Real estate secured - commercial			7		5,087
		Consumer			64		468
		Total			119	$	15,295
Originated loans and leases					111	$	14,692
Purchased loans and leases					8		603
		Total			119	$	15,295

28

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

			Recorded Investment
								Financial Effect of
				Pre-Modification		Post-Modification		Modification
			Number of	Recorded		Recorded		Recorded
Nine months ended September 30, 2012			Loans	Investment		Investment		Investment(1)		Interest (2)
Troubled Debt Restructurings
	Commercial, financial, and agricultural
		Other (3)	8	$	787	$	787	$	0	$	0
		Combination of modification types	0		0		0		0		0
	Real estate - construction
		Other (3)	2		343		343		0		0
		Combination of modification types	0		0		0		0		0
	Real estate secured - residential
		Other (3)	59		5,776		5,776		0		0
		Combination of modification types	17		4,213		4,213		0		0
	Real estate secured - commercial
		Other (3)	6		1,539		1,539		0		0
		Combination of modification types	0		0		0		0		0
	Consumer
		Other (3)	35		300		300		0		0
		Combination of modification types	0		0		0		0		0
	Total		127	$	12,958	$	12,958	$	0	$	0
Originated loans and leases			97	$	8,255	$	8,255	$	0	$	0
Purchased loans and leases			30		4,703		4,703		0		0
	Total		127	$	12,958	$	12,958	$	0	$	0
(1)	Financial effects impacting the recorded investment include principal payments, advances, charge-offs, and capitalized past-due amounts.
(2)	Represents the present value of interest rate concessions discounted at the effective rate of the original loan.
(3)	Bankruptcies and maturity date extensions.
					Number of	Recorded
					Loans	Investment
Troubled Debt Restructurings that Subsequently
	Defaulted during the current period
		Commercial, financial, and agricultural			1	$	351
		Real estate - construction			0		0
		Real estate secured - residential			7		1,981
		Real estate secured - commercial			1		199
		Consumer			0		0
		Total			9	$	2,531
Originated loans and leases					8	$	2,157
Purchased loans and leases					1		374
		Total			9	$	2,531

29

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

The unpaid principal balance and the related carrying amount of acquired loans are as follows:
				September 30,		December 31,
				2013		2012
	Credit impaired purchased loans evaluated individually for
		incurred credit losses
			Unpaid principal balance	$	179,556	$	238,538
			Carrying amount		138,503		162,251
	Other purchased loans evaluated collectively for incurred credit
		losses
			Unpaid principal balance		1,619,425		1,976,132
			Carrying amount		1,615,488		1,967,032
	Total purchased loans
			Unpaid principal balance		1,798,981		2,214,670
			Carrying amount		1,753,991		2,129,283

The changes in the accretable discount related to the purchased credit impaired loans are as follows:
		Three Months Ended				Nine Months Ended
		September 30,				September 30,
		2013		2012		2013		2012
Balance - beginning of period		$	49,187	$	50,527	$	62,868	$	4,881
	Tower acquisition		0		0		0		54,418
	Accretion to interest income		(4,229)		(4,902)		(16,522)		(13,674)
	Net reclassification to non-accretable from accretable		1,481		12,299		93		12,299
Balance - end of period		$	46,439	$	57,924	$	46,439	$	57,924

NOTE 5. Allowance for Loan and Lease Losses

In establishing the allowance for credit losses, Susquehanna estimates losses attributable to specific impaired credits identified through the credit review processes and also estimates losses inherent in other loans and leases on a collective basis. For purposes of determining the level of the allowance for credit losses, Susquehanna evaluates its loan and lease portfolio by loan type. The losses provisioned for in Susquehanna’s allowance for loan loss is determined through a loan by loan analysis of larger balance commercial and commercial real estate loans that show signs of credit deterioration and by applying loss factors to groups of loan balances based on loan type and management’s classification of such loans under the Susquehanna’s loan grading system, adjusted for qualitative considerations.  In determining the allowance for credit losses, Susquehanna utilizes an internal loan grading system for its commercial portfolio.  The internal loan gradings are monitored by Susquehanna’s loan review department.  Additionally, loans that are part of a relationship of over $1.0 million and have a rating of substandard, special mention, and pass that are on Susquehanna’s watch list, are reviewed on a quarterly basis at Susquehanna’s Loan Quality Review Committee.  Factors considered at the Loan Quality Review meetings include the financial statements of the borrower, the borrower’s global cash flow, guarantees, and underlying collateral valuations.

30

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

		An analysis of the allowance for loan and lease losses for the three and nine months ended September 30, 2013 and 2012 are presented in the following tables:
					Three Months Ended September 30, 2013
									Real Estate		Real Estate
							Real Estate -		Secured -		Secured -
					Commercial		Construction		Residential		Commercial		Consumer		Leases		Unallocated		Total
Allowance for credit losses:
Balance at July 1, 2013					$	30,237	$	23,568	$	37,716	$	68,827	$	3,155	$	14,750	$	341	$	178,594
	Charge-offs					(5,892)		(8,103)		(4,151)		(6,043)		(1,051)		(694)		0		(25,934)
	Recoveries					2,161		1,599		627		4,036		325		332		0		9,080
	Provision					4,491		6,910		(4,995)		(1,602)		(479)		640		35		5,000
Balance at September 30, 2013					$	30,997	$	23,974	$	29,197	$	65,218	$	1,950	$	15,028	$	376	$	166,740
					Nine Months Ended September 30, 2013
									Real Estate		Real Estate
							Real Estate -		Secured -		Secured -
					Commercial		Construction		Residential		Commercial		Consumer		Leases		Unallocated		Total
Allowance for credit losses:
Balance at January 1, 2013					$	30,207	$	25,171	$	41,276	$	70,053	$	3,722	$	13,341	$	250	$	184,020
	Charge-offs					(26,758)		(14,036)		(9,771)		(11,488)		(2,397)		(3,015)		0		(67,465)
	Recoveries					6,197		3,786		1,879		6,841		886		1,596		0		21,185
	Provision					21,351		9,053		(4,187)		(188)		(261)		3,106		126		29,000
Balance at September 30, 2013					$	30,997	$	23,974	$	29,197	$	65,218	$	1,950	$	15,028	$	376	$	166,740
Balance at September 30, 2013
	Individually evaluated for impairment:
			Originated loans and leases		$	1,853	$	1,762	$	1,440	$	6,614	$	49	$	0			$	11,718
			Purchased loans and leases			1,276		343		1,175		792		1		0				3,587
				Total	$	3,129	$	2,105	$	2,615	$	7,406	$	50	$	0			$	15,305
	Collectively evaluated for impairment:
			Originated loans and leases		$	26,916	$	21,839	$	26,596	$	58,772	$	1,908	$	15,028	$	376	$	151,435
			Purchased loans and leases			0		0		0		0		0		0		0		0
				Total	$	26,916	$	21,839	$	26,596	$	58,772	$	1,908	$	15,028	$	376	$	151,435
Financing receivables:
Balance at September 30, 2013					$	2,273,735	$	765,246	$	4,145,522	$	4,109,329	$	935,117	$	1,147,505			$	13,376,454
Balance at September 30, 2013
	Individually evaluated for impairment:
			Originated loans and leases		$	12,236	$	13,905	$	33,910	$	64,143	$	1,730	$	0			$	125,924
			Purchased loans and leases			16,199		12,320		29,274		80,446		264		0				138,503
				Total	$	28,435	$	26,225	$	63,184	$	144,589	$	1,994	$	0			$	264,427
	Collectively evaluated for impairment:
			Originated loans and leases		$	2,133,682	$	660,317	$	3,317,817	$	3,311,119	$	926,099	$	1,147,505			$	11,496,539
			Purchased loans and leases			111,618		78,704		764,521		653,621		7,024		0				1,615,488
				Total	$	2,245,300	$	739,021	$	4,082,338	$	3,964,740	$	933,123	$	1,147,505			$	13,112,027

31

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

				Three Months Ended September 30, 2012
								Real Estate		Real Estate
						Real Estate -		Secured -		Secured -
				Commercial		Construction		Residential		Commercial		Consumer		Leases		Unallocated		Total
Allowance for credit losses:
Balance at July 1, 2012				$	30,062	$	31,670	$	33,794	$	78,500	$	3,314	$	12,857	$	431	$	190,628
	Charge-offs				(5,986)		(3,264)		(2,649)		(9,750)		(616)		(955)		0		(23,220)
	Recoveries				2,229		355		179		311		168		247		0		3,489
	Provision				962		1,144		8,649		4,279		553		674		(261)		16,000
Balance at September 30, 2012				$	27,267	$	29,905	$	39,973	$	73,340	$	3,419	$	12,823	$	170	$	186,897
				Nine Months Ended September 30, 2012
								Real Estate		Real Estate
						Real Estate -		Secured -		Secured -
				Commercial		Construction		Residential		Commercial		Consumer		Leases		Unallocated		Total
Allowance for credit losses:
Balance at January 1, 2012				$	28,567	$	36,868	$	28,839	$	78,414	$	3,297	$	10,561	$	1,554	$	188,100
	Charge-offs				(18,979)		(12,733)		(9,831)		(20,199)		(2,327)		(2,946)		0		(67,015)
	Recoveries				5,969		2,007		1,156		4,004		898		778		0		14,812
	Provision				11,710		3,763		19,809		11,121		1,551		4,430		(1,384)		51,000
Balance at September 30, 2012				$	27,267	$	29,905	$	39,973	$	73,340	$	3,419	$	12,823	$	170	$	186,897
Balance at September 30, 2012
	Individually evaluated for impairment:
		Originated loans and leases		$	907	$	1,309	$	4,872	$	8,672	$	117	$	0			$	15,877
		Purchased loans and leases			0		528		965		254		0		0				1,747
			Total	$	907	$	1,837	$	5,837	$	8,926	$	117	$	0			$	17,624
	Collectively evaluated for impairment:
		Originated loans and leases		$	26,360	$	28,068	$	34,136	$	64,414	$	3,302	$	12,823	$	170	$	169,273
		Purchased loans and leases			0		0		0		0		0		0		0		0
			Total	$	26,360	$	28,068	$	34,136	$	64,414	$	3,302	$	12,823	$	170	$	169,273
Financing receivables:
Balance at September 30, 2012				$	2,168,708	$	904,285	$	4,047,761	$	3,947,447	$	829,760	$	777,646			$	12,675,607
Balance at September 30, 2012
	Individually evaluated for impairment:
		Originated loans and leases		$	13,532	$	21,157	$	22,432	$	59,619	$	306	$	0			$	117,046
		Purchased loans and leases			17,438		27,734		26,363		96,366		117		0				168,018
			Total	$	30,970	$	48,891	$	48,795	$	155,985	$	423	$	0			$	285,064
	Collectively evaluated for impairment:
		Originated loans and leases		$	1,943,900	$	652,551	$	3,151,668	$	2,939,893	$	816,898	$	777,646			$	10,282,556
		Purchased loans and leases			193,838		202,843		847,298		851,569		12,439		0				2,107,987
			Total	$	2,137,738	$	855,394	$	3,998,966	$	3,791,462	$	829,337	$	777,646			$	12,390,543

32

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

NOTE 6. Goodwill

Goodwill is allocated to Susquehanna’s reporting units at the date the goodwill is initially recorded. Once goodwill has been allocated to the reporting units, it generally no longer retains its identification with a particular acquisition, but instead becomes identified with the reporting unit as a whole. As a result, all of the fair value of each reporting unit is available to support the value of goodwill allocated to the unit. Goodwill impairment testing is performed at the reporting unit level, one level below the business segment.

The goodwill impairment analysis is done in two steps. The first step requires a comparison of the fair value of the individual reporting unit to its carrying value, including goodwill. If the fair value of the reporting unit is in excess of the carrying value, the related goodwill is considered not to be impaired and no further analysis is necessary. If the carrying value of the reporting unit exceeds the fair value, there is an indication of potential impairment and a second step of testing is performed to measure the amount of impairment, if any, for the reporting unit.

Susquehanna assesses goodwill for impairment on an annual basis, or more often if events or circumstances indicate that goodwill may be impaired. This assessment requires significant judgment and analysis.

Susquehanna performed its annual goodwill impairment assessments in the second quarter of 2013 and determined that the fair value of each of its reporting units exceeded its book value, and that there was no goodwill impairment.

Bank Reporting Unit

Goodwill assigned to the bank reporting unit at the annual assessment dates of May 31, 2013 and 2012 was $1,165,200 and $1,158,248, respectively. Fair value of the bank reporting unit was determined using a market approach, which uses prices and other relevant information reported for market transactions involving recent non-distressed sales of comparable financial institutions in the United States, with particular consideration given to transactions within Susquehanna’s market, to value the bank reporting unit. In 2013, Susquehanna increased the number of key ratios in measuring the fair value of the bank reporting unit from two to three, adding a price to earnings ratio. The addition of the price to earnings ratio, and its corresponding use in valuations, is appropriate given the return to more normalized profitability of the banking industry, as a whole, from the economic downturn experienced during the past several years.  The following table shows the ratios used at May 31, 2013, and 2012.

		Annual	Annual
Ratio		May 31, 2013	May 31, 2012
Price to book		1.57x	1.29x
Price to tangible book		1.80x	1.47x
Price to earnings(1)		22.1x	NA
(1)	Last twelve months earnings.

Fair value of the bank reporting unit exceeded carrying value by 44.6% at May 31, 2013, and by 5.9% at May 31, 2012. Since the fair value of the reporting unit is in excess of the carrying value, the related goodwill is considered not to be impaired and the second step in the analysis is unnecessary.

Wealth Management Reporting Unit

Goodwill assigned to the wealth management reporting unit at the annual assessment dates of May 31, 2013 and 2012 was $82,746 for both periods. Fair value of the wealth management reporting unit was determined utilizing the market approach and the income approach. The market approach measures the fair value of the reporting unit using transaction multiples reported for market transactions involving comparable wealth management business. The income approach measures the fair value of the reporting unit by converting the reporting unit’s future earnings over ten years, assuming a weighted increase in the reporting unit’s revenues and a weighted increase in the reporting unit’s expenses, to a single present (discounted) amount, based on a discount rate. In keeping with a market participant’s current valuations of wealth management institutions, Susquehanna predominantly uses the income approach. The following table shows the factors used in the income approach at May 31, 2013, and 2012.

33

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

	Annual	Annual
Factors	May 31, 2013	May 31, 2012
Discount rate	18.4%	17.5%
Weighted-average increase in revenues	5.0%	6.0%
Weighted-average increase in expenses	3.0%	5.0%

Fair value of the wealth management reporting unit exceeded carrying value by 45.9% at May 31, 2013 and by 63.4% at May 31, 2012. Since the fair value of the reporting unit is in excess of the carrying value, the related goodwill is considered not to be impaired and the second step in the analysis is unnecessary.

Property and Casualty Insurance Reporting Unit

Goodwill assigned to the property and casualty insurance reporting unit at the annual assessment dates of May 31, 2013 and 2012, was $17,177 for both periods. Fair value of the property and casualty insurance reporting unit was determined using the market approach, which measures the fair value of the reporting unit using recent sales of comparable property and casualty insurance companies in Susquehanna’s market. Susquehanna uses two key ratios to measure the fair value of the property and casualty insurance reporting unit: average price to book and median price to earnings. The following table shows the ratios used at May 31, 2013, and 2012.

	Annual	Annual
Ratio	May 31, 2013	May 31, 2012
Average price to book	1.15X	1.17X
Median price to earnings	18.1X	12.1X

Fair value of the property and casualty insurance reporting unit exceeded carrying value by 21.7% at May 31, 2013 and by 7.3% at May 31, 2012. Since the fair value of the reporting unit is in excess of the carrying value, the related goodwill is considered not to be impaired and the second step in the analysis is not required.

NOTE 7. Deposits
	Deposits consisted of the following at September 30, 2013 and December 31, 2012:
		September 30,		December 31,
		2013		2012
Noninterest-bearing:
	Demand	$	1,871,461	$	1,973,664
Interest-bearing:
	Interest-bearing demand		5,957,982		5,829,147
	Savings		1,065,699		1,032,293
	Time		2,103,650		2,262,262
	Time of $100 or more		1,722,893		1,482,680
Total deposits		$	12,721,685	$	12,580,046

NOTE 8.  Income Taxes

Our effective tax rate for the three and nine months ended September 30, 2013 was 31.4% and 31.1%, respectively.  Our effective tax rate for the three and nine months ended September 30, 2012 was 31.8% and 31.6%, respectively.  The decrease in tax rate was due to the amount of tax-advantaged income relative to total income for the three and nine months ended September 30, 2013, as compared to the tax-advantaged income relative to total income for the three and nine months ended September 30, 2012 as well as a reduction in state income tax expense.  The estimated annual effective rates for the reporting periods ended September 30, 2013 and September 30, 2012 were impacted by the level of permanent differences, including tax-advantaged income, resulting in an effective rate below statutory rates for the interim reporting periods.

34

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

NOTE 9. Accumulated Other Comprehensive Loss
		The balances and changes in balances by component of accumulated other comprehensive income (loss) are shown in the following tables:
									Unrealized				Accumulated
					Unrealized Gains (Losses) on				Gains (Losses)		Post-		Other
					Investment securities				on Cash Flow		retirement		Comprehensive
					With OTTI		All other		Hedges		Benefits		Loss
Balance, July 1, 2013					$	(750)	$	(414)	$	(25,437)	$	(39,321)	$	(65,922)
	AOCI before reclassifications, net of tax					150		1,994		(2,434)		0		(290)
	Amounts reclassified from AOCI:
		Interest expense				0		0		5,023		0		5,023
		Net realized loss (gain) on sales of securities				0		(2)		0		0		(2)
			Total before income taxes			0		(2)		5,023		0		5,021
			Less: Income taxes			0		1		(1,758)		0		(1,757)
				Net of income taxes		0		(1)		3,265		0		3,264
	Net change in AOCI					150		1,993		831		0		2,974
Balance, September 30, 2013					$	(600)	$	1,579	$	(24,606)	$	(39,321)	$	(62,948)
Balance, July 1, 2012					$	(1,461)	$	27,692	$	(35,883)	$	(33,475)	$	(43,127)
	AOCI before reclassifications, net of tax					86		13,355		(4,541)		0		8,900
	Sale of securities for which other-than-temporary
		impairment was previously recognized, net of tax				0		0		0		0		0
	Amounts reclassified from AOCI:
		Interest expense				0		0		4,434		0		4,434
		Net realized loss (gain) on sales of securities				0		(31)		0		0		(31)
			Total before income taxes			0		(31)		4,434		0		4,403
			Less: Income taxes			0		11		(1,552)		0		(1,541)
				Net of income taxes		0		(20)		2,882		0		2,862
	Net change in AOCI					86		13,335		(1,659)		0		11,762
Balance, September 30, 2012					$	(1,375)	$	41,027	$	(37,542)	$	(33,475)	$	(31,365)
Balance, January 1, 2013					$	(839)	$	37,521	$	(34,636)	$	(39,304)	$	(37,258)
	AOCI before reclassifications, net of tax					(76)		(35,660)		784		(17)		(34,969)
	Amounts reclassified from AOCI:
		Interest expense				0		0		14,225		0		14,225
		Net realized loss (gain) on sales of securities				485		(434)		0		0		51
			Total before income taxes			485		(434)		14,225		0		14,276
			Less: Income taxes			(170)		152		(4,979)		0		(4,997)
				Net of income taxes		315		(282)		9,246		0		9,279
	Net change in AOCI					239		(35,942)		10,030		(17)		(25,690)
Balance, September 30, 2013					$	(600)	$	1,579	$	(24,606)	$	(39,321)	$	(62,948)
Balance, January 1, 2012					$	(2,564)	$	23,388	$	(33,403)	$	(33,475)	$	(46,054)
	AOCI before reclassifications, net of tax					(1,826)		18,794		(12,643)		0		4,325
	Sale of securities for which other-than-temporary
		impairment was previously recognized, net of tax				2,892		0		0		0		2,892
	Amounts reclassified from AOCI:
		Interest expense				0		0		13,083		0		13,083
		Net realized loss (gain) on sales of securities				190		(1,823)		0		0		(1,633)
			Total before income taxes			190		(1,823)		13,083		0		11,450
			Less: Income taxes			(67)		668		(4,579)		0		(3,978)
				Net of income taxes		123		(1,155)		8,504		0		7,472
	Net change in AOCI					1,189		17,639		(4,139)		0		14,689
Balance, September 30, 2012					$	(1,375)	$	41,027	$	(37,542)	$	(33,475)	$	(31,365)

35

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

NOTE 10. Share-based Compensation

During the nine months ended September 30, 2013 and 2012, Susquehanna’s Compensation Committee granted to certain employees nonqualified stock options to purchase an aggregate of 4 and  313 shares of common stock, respectively. The following table presents the assumptions used in the Black-Scholes-Merton model to estimate the fair value of options granted in 2013 and 2012, and the resultant fair values.

	Nine Months Ended September 30,
	2013			2012
Exercise price	$	11.47		$	9.89
Volatility		37.80	%		37.61	%
Expected dividend yield		4.00	%		4.00	%
Expected term (in years)		7.0			7.0
Risk-free interest rate		1.22	%		1.09	%
Fair value	$	2.81		$	2.40

In 2013, Susquehanna’s Board of Directors approved the 2013 Omnibus Equity Compensation Plan (“the Plan”). The Plan provides key executives with long-term incentives based on performance, service, and market conditions, as a motivation for future performance and as a retention tool for continued employment. The Plan is a multi-year performance plan, with stock-based incentive award opportunities if certain performance targets are met. The Plan is funded by newly authorized shares, and at September 30, 2013, approximately 374 shares have been allocated to the Plan.

NOTE 11. Pension and Other Postretirement Benefits
Components of Net Periodic Benefit Cost
		Three Months Ended September 30,
										Other Postretirement
		Pension Benefits				SERP				Benefits
		2013		2012		2013		2012		2013		2012
Service cost		$	1,055	$	1,149	$	69	$	530	$	337	$	272
Interest cost			1,835		1,756		100		109		217		201
Expected return on plan assets			(2,267)		(2,179)		0		0		0		0
Amortization of prior service cost			6		7		54		100		29		29
Amortization of transition obligation			0		0		0		0		2		28
Amortization of net actuarial (gain) or loss			884		538		52		(6)		42		16
	Net periodic postretirement benefit cost	$	1,513	$	1,271	$	275	$	733	$	627	$	546
			Nine Months Ended September 30,
										Other Postretirement
		Pension Benefits				SERP				Benefits
		2013		2012		2013		2012		2013		2012
Service cost		$	3,721	$	3,551	$	695	$	598	$	1,012	$	816
Interest cost			5,423		5,308		304		258		651		603
Expected return on plan assets			(7,091)		(6,877)		0		0		0		0
Amortization of prior service cost			19		20		163		155		86		85
Amortization of transition obligation			0		0		0		0		6		85
Amortization of net actuarial (gain) or loss			2,398		2,146		165		103		126		47
	Net periodic postretirement benefit cost	$	4,470	$	4,148	$	1,327	$	1,114	$	1,881	$	1,636

36

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

Employer Contributions

Susquehanna previously disclosed in its financial statements for the year ended December 31, 2012, that it expected to contribute $365 to its pension plans and $621 to its other postretirement benefit plan in 2013. As of September 30, 2013, $274 of contributions had been made to its pension plans, and $466 of contributions had been made to its other postretirement benefit plan. Susquehanna anticipates contributing an additional $91 to fund its pension plans in 2013, for a total of $365, and an additional $155 to it other postretirement benefit plan, for a total of $621.

Plan Change

Susquehanna changed the pension plan during September 2013, with an effective date of December 31, 2013.  Susquehanna will cease providing future pay-based increases to accounts for eligible employees.  Eligible employees will continue to receive interest each year at a guaranteed minimum of 5.0%.  Employees in this group will also receive an automatic contribution to the Susquehanna 401(k) plan equal to 2.0% of their eligible compensation.

NOTE 12. Earnings per Share ("EPS")
	The following tables set forth the calculation of basic and diluted EPS for the three-month and nine-month periods ended
September 30, 2013 and 2012.
Basic earnings per common share
		Three Months Ended September 30,				Nine Months Ended September 30,
		2013		2012		2013		2012
Net income applicable to common shareholders		$	44,291	$	36,732	$	132,338	$	97,998
Weighted average common shares outstanding			187,096		186,214		186,840		181,735
Basic earnings per common share		$	0.24	$	0.20	$	0.71	$	0.54
Diluted earnings per common share
		Three Months Ended September 30,				Nine Months Ended September 30,
		2013		2012		2013		2012
Net income available to common shareholders		$	44,291	$	36,732	$	132,338	$	97,998
Weighted average common shares outstanding			187,096		186,214		186,840		181,735
Dilutive potential common shares			1,013		790		976		752
Total diluted average common shares outstanding			188,109		187,004		187,816		182,487
Diluted earnings per common share		$	0.24	$	0.20	$	0.70	$	0.54

For the three months ended September 30, 2013 and 2012, weighted average options to purchase 1,455 and 1,929 shares, respectively, were outstanding but were not included in the computation of diluted EPS because the effect of the options would have been antidilutive for the period. For the nine months ended September 30, 2013 and 2012, weighted average options to purchase 1,494 and 2,039 shares, respectively, were outstanding but were not included in the computation of diluted EPS because the effect of the options would have been antidilutive for the period.

37

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

NOTE 13. Derivative Financial Instruments

Risk Management Objective of Using Derivatives

Susquehanna is exposed to certain risks arising from both its business operations and economic conditions. Susquehanna manages economic risk exposures, including interest rate, liquidity, and credit risk, primarily by managing the amount, sources, and duration of its assets and liabilities and through the use of derivative financial instruments. Susquehanna enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are impacted by changes in interest rates. Susquehanna’s derivative financial instruments are used to manage differences in the amount, timing, and duration of its known or expected cash payments principally those related to certain variable-rate liabilities. Susquehanna also has derivatives that are a result of a service it provides to certain qualifying customers. Susquehanna manages a matched book with respect to its derivative instruments offered as a part of this service to its customers in order to minimize its interest rate risk resulting from such transactions. All derivatives are recorded at fair value.

Derivatives may expose Susquehanna to market, credit or liquidity risks in excess of the amounts recorded on the consolidated balance sheets. Market risk of a derivative is the exposure created by potential fluctuations in interest rates and other factors and is a function of the type of derivative, the tenor and terms of the agreement, and the underlying volatility. Credit risk is the exposure to loss in the event of nonperformance by the other party to the transaction where the value of any collateral held is not adequate to cover such losses. Liquidity risk is the potential exposure that arises when the size of the derivative position may not be able to be rapidly adjusted in periods of high volatility and financial stress at a reasonable cost.

All freestanding derivatives are recorded on the balance sheet at fair value.

Cash Flow Hedges of Interest Rate Risk

Susquehanna uses interest rate derivatives to manage its exposure to interest rate movements and add stability to interest income and expense. Susquehanna primarily uses interest rate swaps as part of its interest rate risk management strategy. For example, Susquehanna may issue variable-rate debt and then enter into a receive-variable pay-fixed-rate interest rate swap with the same payment timing and notional amount to convert the interest payments to a net fixed-rate basis for all or a portion of the term of the long-term debt. As of September 30, 2013, December 31, 2012, and September 30, 2012, Susquehanna had 14 interest rate swaps, respectively for each period, with an aggregate notional amount of $1,148,328, $1,154,363, and $1,156,473, respectively, that were designated as cash flow hedges of interest-rate risk.

Susquehanna applies hedge accounting to certain interest rate derivatives entered into for risk management purposes. To qualify for hedge accounting, a derivative must be highly effective at reducing the risk associated with the exposure being hedged. In addition, key aspects of achieving hedge accounting are documentation of hedging strategy and hedge effectiveness at the hedge inception and substantiating hedge effectiveness on an ongoing basis. A derivative must be highly effective in accomplishing the hedge objective of offsetting either changes in the fair value or cash flows of the hedged item for the risk being hedged. Any ineffectiveness in the hedge relationship is recognized in current earnings. The assessment of effectiveness excludes changes in the value of the hedged item that are unrelated to the risks being hedged. The effective portion of changes in the fair value of derivatives designated in a hedge relationship and that qualify as cash flow hedges is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings in the period that the hedged transaction affects earnings.

Amounts recorded in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on Susquehanna’s variable-rate liabilities. During the 12 months following September 30, 2013, Susquehanna estimates that $21,220 will be reclassified as an expense to net interest income.

Non-designated Derivatives

Susquehanna does not seek to apply hedge accounting to all of the derivatives involved in Susquehanna’s risk management activities.  Derivatives not designated as hedges are used to manage Susquehanna’s exposure to interest rate movements and other identified risks but do not meet the strict requirements of hedge accounting. Changes in the fair value of derivatives not designated in hedging relationships are recognized directly in earnings.

Susquehanna offers qualifying commercial banking customers derivatives to enable such customers to transfer, modify or reduce their interest rate risks. The credit risk associated with derivatives entered into with these customers is essentially the same as that involved in extending loans and is subject to our normal credit policies. Susquehanna actively manages the market risks from its exposure to these derivatives by entering into offsetting derivative transactions, controls focused on pricing, and reporting of positions to senior managers to minimize its exposure resulting from such transactions. 

38

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

Susquehanna in the normal course of its mortgage banking activities, enters into commitments to extend credit, at an agreed upon interest rate, to borrowers for the purpose of origination and/or purchase of loans.  These commitments expose Susquehanna to interest rate risk.  To mitigate the effect of this interest rate risk, Susquehanna enters into derivative contracts, primarily forward loan sale commitments.  The forward loan commitments lock in an interest rate and price for the sale of loans similar to the specific rate lock loan commitments.  Both the rate lock commitments and the forward loan sale commitments are undesignated derivatives, and accordingly are marked to market through earnings.

At September 30, 2013 and 2012, Susquehanna had 232 and 168 derivative transactions, respectively, related to these risk management activities with an aggregate notional amount of $1,540,599 and $890,124, respectively. For the three-month and nine-month periods ended September 30, 2013, Susquehanna recognized a net gain of $1,545 and $3,159, respectively, and for the three-month and nine-month periods ended September 30, 2012, Susquehanna recognized a net loss of $4,064 and $4,870, respectively, related to changes in fair value of the derivatives in this program.

Credit-risk-related Contingent Features

Susquehanna has agreements with certain of its derivative counterparties that contain the following provisions:

·if Susquehanna defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, then Susquehanna could also be declared in default on its derivative obligations;

·if Susquehanna fails to maintain its status as a well/adequately capitalized institution, then the counterparty could terminate the derivative positions, and Susquehanna would be required to settle its obligations under the agreements;

·if Susquehanna fails to maintain a specified minimum leverage ratio, then Susquehanna could be declared in default on its derivative obligations;

·if Susquehanna’s credit rating is reduced below investment grade, then a termination event will be deemed to have occurred and Susquehanna’s counterparty would have the right, but not the obligation, to terminate all transactions under the agreement.

At September 30, 2013 and December 31, 2012, the fair value of derivatives in a net liability position, which includes any credit valuation adjustments related to these agreements, was $54,712 and $72,126, respectively. At September 30, 2013 and December 31, 2012, Susquehanna had minimum collateral posting thresholds with certain of its derivative counterparties and had posted cash collateral of $44,828 and $75,103, respectively. If Susquehanna had breached any of the above provisions at September 30, 2013, it would have been required to settle its obligations under the agreements at termination value and would have been required to pay any additional amounts due in excess of amounts previously posted as collateral with the respective counterparty.

39

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

Fair Value of Derivative Instruments
		Fair Values of Derivative Instruments
		September 30, 2013
		Asset Derivatives			Liability Derivatives
		Balance Sheet			Balance Sheet
		Location	Fair Value		Location	Fair Value
Derivatives designated as hedging instruments
	Interest rate contracts	Other assets	$	1,457	Other liabilities	$	36,209
Derivatives not designated as hedging instruments
	Interest rate contracts	Other assets		21,479	Other liabilities		18,503
Total derivatives			$	22,936		$	54,712
		Fair Values of Derivative Instruments
		December 31, 2012
		Asset Derivatives			Liability Derivatives
		Balance Sheet			Balance Sheet
		Location	Fair Value		Location	Fair Value
Derivatives designated as hedging instruments
	Interest rate contracts	Other assets	$	878	Other liabilities	$	51,172
Derivatives not designated as hedging instruments
	Interest rate contracts	Other assets		25,037	Other liabilities		20,954
Total derivatives			$	25,915		$	72,126

40

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

The Effect of Derivative Instruments on Comprehensive Income
Three Months Ended September 30, 2013
							Location of Loss	Amount of Loss
			Location of Loss		Amount of Loss		Recognized in	Recognized in
	Amount of Gain		Reclassified from		Reclassified from		Income	Income
Derivatives in Cash Flow	Recognized		Accumulated OCI		Accumulated OCI		(Ineffective	(Ineffective
Hedging Relationships	in OCI		into Income		into Income		Portion)	Portion)
Interest rate contracts:	$	831		Interest expense	$	(5,023)	Other expense	$	0
		Location of Gain	Amount of Gain
		Recognized	Recognized
Derivatives Not Designated		in Income	in Income
as Hedging Instruments		on Derivatives	on Derivatives
Interest rate contracts:		Other income	$	1,545
		Other expense		0
Three Months Ended September 30, 2012
							Location of Loss	Amount of Loss
			Location of Loss		Amount of Loss		Recognized in	Recognized in
	Amount of Loss		Reclassified from		Reclassified from		Income	Income
Derivatives in Cash Flow	Recognized		Accumulated OCI		Accumulated OCI		(Ineffective	(Ineffective
Hedging Relationships	in OCI		into Income		into Income		Portion)	Portion)
Interest rate contracts:	$	(1,659)		Interest expense	$	(4,434)	Other expense	$	0
		Location of Loss	Amount of Loss
		Recognized	Recognized
Derivatives Not Designated		in Income	in Income
as Hedging Instruments		on Derivatives	on Derivatives
Interest rate contracts:		Other income	$	(4,054)
		Other expense		(10)

41

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

Nine Months Ended September 30, 2013
							Location of Loss	Amount of Loss
			Location of Loss		Amount of Loss		Recognized in	Recognized in
	Amount of Gain		Reclassified from		Reclassified from		Income	Income
Derivatives in Cash Flow	Recognized		Accumulated OCI		Accumulated OCI		(Ineffective	(Ineffective
Hedging Relationships	in OCI		into Income		into Income		Portion)	Portion)
Interest rate contracts:	$	10,030		Interest expense	$	(14,225)	Other expense	$	0
		Location of Gain	Amount of Gain
		(Loss) Recognized	(Loss) Recognized
Derivatives Not Designated		in Income on	in Income on
as Hedging Instruments		Derivatives	Derivatives
Interest rate contracts:		Other income	$	3,160
		Other expense		(1)
Nine Months Ended September 30, 2012
							Location of Loss	Amount of Loss
			Location of Loss		Amount of Loss		Recognized in	Recognized in
	Amount of Loss		Reclassified from		Reclassified from		Income	Income
Derivatives in Cash Flow	Recognized		Accumulated OCI		Accumulated OCI		(Ineffective	(Ineffective
Hedging Relationships	in OCI		into Income		into Income		Portion)	Portion)
Interest rate contracts:	$	(4,139)		Interest expense	$	(13,083)	Other expense	$	0
		Location of Loss	Amount of Loss
		Recognized	Recognized
Derivatives Not Designated		in Income	in Income
as Hedging Instruments		on Derivatives	on Derivatives
Interest rate contracts:		Other income	$	(4,823)
		Other expense		(47)

42

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

NOTE 14.  Balance Sheet Offsetting

Assets and liabilities relating to certain financial instruments, including derivatives and securities sold under agreements to repurchase, may be eligible for offset in the consolidated balance sheet as permitted under accounting guidance.  Susquehanna is party to transactions involving derivative instruments that are subject to master netting arrangements or similar agreements.  Under these agreements, Susquehanna may have the right to net settle multiple contracts with the same counterparty.  Certain derivative transactions may require Susquehanna to receive or pledge cash collateral based on the contract provisions.

Susquehanna also enters into agreements in which it sells securities subject to an obligation to repurchase the same or similar securities.  Under these agreements, Susquehanna may transfer legal control over the assets but still retain effective control through an agreement that both entitles and obligates Susquehanna to repurchase the assets.  The obligation to repurchase the securities is reflected as a liability in Susquehanna’s consolidated balance sheet, while the securities underlying the repurchase agreements remain in the respective investment securities account, therefore there is no offsetting or netting of the investment securities assets with the repurchase agreement liability.

Susquehanna also offers derivative products to qualifying customers and enters into offsetting derivative transactions in due course.  Susquehanna manages a matched book with respect to its derivative instruments offered as part of this service to its customers in order to minimize its interest rate risk resulting from such transactions.  These instruments are free-standing derivatives and are recorded at fair value on the consolidated balance sheet.  Collateral is posted by the counterparty with net liability positions in accordance with the contract provisions.

Susquehanna is subject to the regulations of the Commodity Futures Trading Commission that require financial institutions to clear all eligible beginning June 2013.  Susquehanna fulfills this obligation by clearing its eligible trades through Futures Commission Merchants (“FCM”) that face designated Derivatives Clearing Organizations (“DCO”) on Susquehanna’s behalf.  Derivatives cleared through the FCMs are presented net in the Consolidated Balance Sheet.  Derivatives originated prior to June 2013 continue to be presented on a gross basis in the Consolidated Balance Sheet.

The following table provides information about financial instruments that are eligible for offset at September 30, 2013 and December 31, 2012:

Balance Sheet Netting Disclosure about Offsetting Assets and Liabilities
							Net Amounts
							Presented in
							the		Gross Amounts Not Offset in the
			Gross				Consolidated		Consolidated Balance Sheet
			Amounts		Gross Amounts		Balance		Financial		Cash
			Recognized		Offset		Sheet		Instruments		Collateral		Net Amount
September 30, 2013
Financial assets:
	Derivatives		$	22,939	$	(3)	$	22,936	$	0	$	(2,720)	$	20,216
Financial liabilities:
	Derivatives		$	54,712	$	0	$	54,712	$	0	$	(44,828)	$	9,884
	Repurchase agreements			310,736		0		310,736		(310,736)		0		0
		Total	$	365,448	$	0	$	365,448	$	(310,736)	$	(44,828)	$	9,884
December 31, 2012
Financial assets:
	Derivatives		$	25,922	$	(7)	$	25,915	$	0	$	0	$	25,915
Financial liabilities:
	Derivatives		$	72,126	$	0	$	72,126	$	0	$	(75,103)	$	(2,977)
	Repurchase agreements			302,577		0		302,577		(302,577)		0		0
		Total	$	374,703	$	0	$	374,703	$	(302,577)	$	(75,103)	$	(2,977)

43

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

		The table below presents the offsetting of derivative assets and derivative liabilities as of September 30, 2013 and December 31,
2012.
				Derivative Assets and Collateral								Derivative Liabilities and Collateral
				Pledged by Counterparty								Held by Counterparty
				Net Amounts		Gross Amounts						Net Amounts		Gross Amounts
				Presented in		Not Offset						Presented in		Not Offset
				the		in the Consolidated						the		in the Consolidated
				Consolidated		Balance Sheet						Consolidated		Balance Sheet
				Balance		Financial		Cash		Net		Balance		Financial		Cash		Net
September 30, 2013				Sheet		Instruments		Collateral		Amount		Sheet		Instruments		Collateral		Amount
Futures Commission
	Merchant Agreements:
		Counterparty:
			FCM A	$	0	$	0	$	0	$	0	$	298	$	0	$	(571)	$	(273)
			FCM B		0		0		0		0		256		0		(517)		(261)
					0		0		0		0		554		0		(1,088)		(534)
Bilateral Agreements:
	Counterparty:
		Dealer A			1,687		0		0		1,687		4,683		0		(3,110)		1,573
		Dealer B			2,087		0		0		2,087		3,911		0		(1,750)		2,161
		Dealer C			217		0		0		217		1,246		0		(900)		346
		Dealer D			3,989		0		(2,720)		1,269		1,127		0		0		1,127
		Dealer E			0		0		0		0		24,078		0		(25,600)		(1,522)
		Dealer F			0		0		0		0		6,066		0		(6,900)		(834)
		Dealer G			0		0		0		0		4,581		0		(4,620)		(39)
		Dealer H			0		0		0		0		987		0		(860)		127
		End User			14,956		0		0		14,956		7,479		0		0		7,479
					22,936		0		(2,720)		20,216		54,158		0		(43,740)		10,418
			Total	$	22,936	$	0	$	(2,720)	$	20,216	$	54,712	$	0	$	(44,828)	$	9,884
December 31, 2012
	Counterparty:
		Dealer A		$	0	$	0	$	0	$	0	$	7,789	$	0	$	(7,820)	$	(31)
		Dealer B			873		0		0		873		6,104		0		(5,050)		1,054
		Dealer C			5		0		0		5		3,460		0		(3,300)		160
		Dealer D			0		0		0		0		3,239		0		(3,350)		(111)
		Dealer E			0		0		0		0		33,598		0		(35,800)		(2,202)
		Dealer F			0		0		0		0		9,105		0		(10,300)		(1,195)
		Dealer G			0		0		0		0		6,623		0		(7,150)		(527)
		Dealer H			0		0		0		0		1,816		0		(1,820)		(4)
		End User			25,037		0		0		25,037		392		0		(513)		(121)
			Total	$	25,915	$	0	$	0	$	25,915	$	72,126	$	0	$	(75,103)	$	(2,977)

44

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

NOTE 15. Fair Value Disclosures

The accounting guidance for fair value measurements and disclosures defines fair value, establishes a framework for measuring fair value, and sets forth disclosure requirements regarding fair value measurements. This guidance applies whenever other accounting guidance requires or permits assets or liabilities to be measured at fair value. Fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place either in the principal market for the asset or liability, or, in the absence of a principal market, in the most advantageous market for the asset or liability.

Susquehanna uses fair value measurements for the initial recording of certain assets and liabilities and periodic subsequent measurement of certain assets and liabilities on a recurring or non-recurring basis.

Fair Value Hierarchy

The accounting guidance for fair value measurements and disclosures establishes a three-level fair value hierarchy that prioritizes the inputs into the valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority, Level 1, to measurements based on quoted prices in active markets for identical assets or liabilities. The next highest priority, Level 2, is given to measurements based on observable inputs other than quoted prices in active markets for identical assets and liabilities. The lowest priority, Level 3, is given to measurements based on unobservable inputs. Assets and liabilities are classified in their entirety within the fair value hierarchy based on the lowest level input that is significant to the fair value measurement.

The accounting guidance requires the measurement of fair value to maximize the use of observable inputs and minimize the use of unobservable inputs. Observable inputs reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the reporting entity. Unobservable inputs reflect Susquehanna’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.

Valuation Processes and Controls over Fair Value Measurement

As part of Susquehanna’s overall valuation process, management employs processes to evaluate and validate the methodologies, techniques and inputs, including review and approval of valuation judgments, methods, models, process controls, and results. These processes are designed to help ensure that the fair value measurements and disclosures are appropriate, consistently applied, and reliable.

Valuation Methodologies and Inputs

The following is a description of Susquehanna’s valuation methodologies and more significant inputs for assets and liabilities measured at fair value. These methods may produce a fair value measurement that may not be indicative of future fair values. Furthermore, while Susquehanna believes that its valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

Susquehanna uses a third-party pricing service and third-party financial advisory firms in determining the fair value of its securities. Certain fair value measurements are derived from market-based pricing matrices that were developed using observable inputs that include benchmark yields, benchmark securities, reported trades, offers, bids, issuer spreads and broker quotes. For certain other fair value measurements, when market observable data is not available due to the lack of an active market for a given security, the valuation of the security involves assistance of a third-party financial advisory firm and substantial judgment by management.

Specific valuation methodologies and inputs used in determining the fair value of each significant class of assets and liabilities follows:

Cash and due from banks and short-term investments

For those short-term instruments, the carrying amount is a reasonable estimate of fair value.

Investment securities

U.S. Government agencies: These are debt securities issued by U.S. government-sponsored entities (“GSE”). These securities are valued using market-based pricing matrices that are based on observable inputs that include benchmark yields, benchmark securities, reported trades, offers, bids, issuer spreads and broker quotes. The investor base is broad, resulting in moderate trading volumes and are classified as Level 2 in the fair value hierarchy. These valuations are sensitive to interest rates. As interest rates increase (decrease), the fair value of the securities will generally decrease (increase).

45

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

Obligations of states and political subdivisions: These securities are valued using market-based pricing matrices that are based on observable inputs including the structure of the bond, including call terms, cross-collateralization features, and tax-exempt features, together with MSRB reported trades, issuer spreads, material event notices and benchmark yield curves. The investor base for most issues of municipal securities is fairly broad, resulting in moderate trading volumes and are classified as Level 2 in the fair value hierarchy. These valuations are sensitive to trends in the broader municipal securities market, which includes credit risk. As market concerns associated with credit risk increase (decrease), the fair value of the securities will generally decrease (increase).

Agency residential mortgage-backed securities: These securities are valued using market-based pricing matrices that are based on observable inputs, including benchmark TBA security pricing and yield curves that were estimated based on U.S. Treasury yields and certain floating rate indices. The pricing matrices for these securities may also give consideration to pool-specific data supplied directly by the GSE. GSE collateralized mortgage obligations (“CMOs”) are valued using market-based pricing matrices that are based on observable inputs including offers, bids, reported trades, dealer quotes and market research reports, the characteristics of a specific tranche, market convention prepayment speeds and benchmark yield curves as described above. Because agency residential mortgage-backed securities are generally liquid and are valued using observable pricing in the market, they generally are classified as Level 2. As interest rates increase (decrease), the fair value of the securities will generally decrease (increase).

Non-agency mortgage-backed securities: Refer to the description in “Note 3-Investment Securities”. 

Commercial mortgage-backed securities: Commercial mortgage-backed securities are valued primarily based on the median prices from multiple pricing services. Some of the important valuation assumptions used by the pricing services include the collateral type, collateral performance, capital structure, issuer, credit enhancement, coupon, weighted average life, and interest rates, coupled with the observed spread levels on trades of similar securities. Many of these securities have significant prepayment lockout periods or penalty periods that limit the window of potential prepayment to a relatively narrow band. These securities are primarily classified as Level 2.

These valuations are sensitive to market changes, specifically changes in interest rates and credit spreads. As interest rates increase (decrease) and/or credit spreads widens (tightens), fair values will typically decrease (increase).

Other structured financial products: The significant unobservable inputs used in the fair value measurement of Susquehanna’s other structured financial products are conditional repayment rate, loss severity, and conditional default rate. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and directionally opposite change in the assumption used for repayment rate. In addition, refer to the description in “Note 3-Investment Securities.”

Other debt securities: These securities consist primarily of government and corporate bonds. These securities are valued using market-based pricing matrices that are based on observable inputs that include benchmark yields, benchmark securities, reported trades, offers, bids, issuer spreads and broker quotes. The investor base is broad, resulting in moderate trading volumes and are classified as Level 2 in the fair value hierarchy. These valuations are sensitive to interest rates. As interest rates increase (decrease), the fair value of the securities will generally decrease (increase).

Other equity securities; These securities include liquid, exchange-traded equity securities as well as thinly-traded bank stocks and trust preferred securities. The exchange-traded equities are classified in Level 1 because they are valued using quoted market prices. The thinly traded and trust preferred securities are classified in Level 2 or 3 based on the significance of market observable inputs to the overall measurement.

Restricted investments in bank stocks

Restricted investments in bank stocks consists of Federal Reserve Bank (“FRB”) stock, Federal Home Loan Bank (“FHLB”) stock, and Atlantic Central Bankers Bank stock. Federal law requires a member institution of the FRB and FHLB to hold stock according to predetermined formulas. Atlantic Central Bankers Bank requires its correspondent banking institutions to hold stock as a condition of membership.  The carrying amount approximates fair value.

Loans and leases

The fair values for loans are estimated using discounted cash flow analyses, applying interest rates currently being offered for loans with similar terms and credit quality, which are indicative of orderly transactions in the current market. For commercial loans and leases, internal risk grades are used to adjust discount rates for risk migration and expected losses. For residential mortgage and

46

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

other consumer loans, internal prepayment risk models are used to adjust contractual cash flows. Loans are aggregated into pools of similar terms and credit quality and discounted using benchmark-based rates. The carrying amount of accrued interest receivable approximates fair value.

Deposits

The fair values of demand, interest-bearing demand, and savings deposits are the amounts payable on demand at the balance sheet date; recognition of the inherent funding value of these instruments is not permitted. The carrying value of variable-rate time deposits approximates fair value. The fair value of fixed-rate time deposits is based upon the discounted value of future cash flows expected to be paid at maturity, using the U.S. Treasury yield curve.   The carrying amount of accrued interest payable approximates fair value.

Short-term borrowings

For those short-term instruments, the carrying amount approximates fair value.

FHLB borrowings and long-term debt

Fair values were based upon quoted rates of similar instruments issued by banking institutions with similar credit ratings. The carrying amounts of accrued interest payable approximate fair values.

Derivatives

The fair values of interest rate swaps are determined using models that use readily observable market inputs and a market standard methodology applied to the contractual terms of the derivatives, including the period to maturity and interest rate indices.

The methodology nets the discounted future fixed cash receipts (or payments) and the discounted expected variable cash payments (or receipts). The variable cash payments (or receipts) are based on an expectation of future interest rates derived from observable market interest rate curves. Susquehanna incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, Susquehanna has considered the impact of netting and any applicable credit enhancements, such as collateral postings and thresholds, mutual settlements, and guarantees.

Although Susquehanna has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives may use Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by itself and its counterparties. However, as of September 30, 2013 and 2012, Susquehanna has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives. As a result, Susquehanna has determined that its derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy.

In the first quarter of 2013 Susquehanna changed its valuation methodology for over-the-counter (“OTC”) derivatives to discount cash flows based on Overnight Index Swap (“OIS”) rates.  Fully collateralized trades are discounted using OIS with no additional economic adjustments to arrive at fair value.  Uncollateralized or partially-collateralized trades are also discounted at OIS, but include appropriate economic adjustments for funding costs, such as a spread between LIBOR and OIS to approximate an uncollateralized cost of funds, and credit risk.  Susquehanna made the changes to reflect inputs, assumptions, and pricing methodologies that are used in its principal market by market participants. 

The fair values of commitments to originate mortgage loans to be held for sale and their corresponding forward-sales agreements are estimated using the fees charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. The valuation of fixed-rate loan commitments also considers the difference between current levels of interest rates and the committed rates. These respective fair value measurements would be categorized within Level 3 of the fair value hierarchy.

For additional information regarding derivatives, refer to “Note 13 – Derivative Financial Instruments” above.

Off-balance-sheet items

The fair values of unused commitments to lend and standby letters of credit are considered to be the same as their contractual amounts.

47

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

Assets and Liabilities Measured at Fair Value on a Recurring Basis
		The following tables present the financial instruments carried at fair value at September 30, 2013 and December 31, 2012, on
the consolidated balance sheets and by levels within the valuation hierarchy.
						Fair Value Measurements at Reporting Date Using
						Quoted Prices in		Significant
						Active Markets for		Other		Significant
						Identical		Observable		Unobservable
						Instruments		Inputs		Inputs
Description				September 30, 2013		(Level 1)		(Level 2)		(Level 3)
Assets
Available-for-sale securities:
	U.S. Government Agencies			$	85,193	$	0	$	85,193	$	0
	Obligations of states and political
		subdivisions			401,278		0		401,278		0
	Agency residential mortgage-backed
		securities			1,884,810		0		1,884,810		0
	Non-agency residential mortgage-
		backed securities			23,596		0		574		23,022
	Commercial mortgage-backed
		securities			10,492		0		10,492		0
	Other structured financial products				11,444		0		0		11,444
	Other debt securities				42,829		0		42,829		0
	Other equity securities				23,733		20,912		0		2,821
Derivatives: (1)
	Designated as hedging instruments				1,457		0		1,457		0
	Not designated as hedging
		instruments			21,479		0		21,479		0
			Total	$	2,506,311	$	20,912	$	2,448,112	$	37,287
Liabilities
Derivatives: (2)
	Designated as hedging instruments			$	36,209	$	0	$	36,209	$	0
	Not designated as hedging
		instruments			18,503		0		18,503		0
			Total	$	54,712	$	0	$	54,712	$	0

48

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

						Fair Value Measurements at Reporting Date Using
						Quoted Prices in		Significant
						Active Markets for		Other		Significant
						Identical		Observable		Unobservable
						Instruments		Inputs		Inputs
Description				December 31, 2012		(Level 1)		(Level 2)		(Level 3)
Assets
Available-for-sale securities:
	U.S. Government Agencies			$	114,408	$	0	$	114,408	$	0
	Obligations of states and political
		subdivisions			435,777		0		435,777		0
	Agency residential mortgage-
		backed securities			1,880,562		0		1,880,562		0
	Non-agency residential mortgage-
		backed securities			27,450		0		650		26,800
	Commercial mortgage-backed
		securities			40,380		0		40,380		0
	Other structured financial products				9,550		0		0		9,550
	Other debt securities				45,255		0		45,255		0
	Other equity securities				24,519		21,266		97		3,156
Derivatives: (1)
	Designated as hedging instruments				878		0		878		0
	Not designated as hedging
		instruments			25,037		0		25,037		0
			Total	$	2,603,816	$	21,266	$	2,543,044	$	39,506
Liabilities
Derivatives: (2)
	Designated as hedging instruments			$	51,172	$	0	$	51,172	$	0
	Not designated as hedging
		instruments			20,954		0		20,954		0
			Total	$	72,126	$	0	$	72,126	$	0
(1)	Included in Other assets
(2)	Included in Other liabilities

49

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

Assets Measured at Fair Value on a Recurring Basis Using Significant Unobservable Inputs
		The following tables present roll-forwards of the balance sheet amounts for the three and nine month periods ended September
30, 2013 and 2012, for financial instruments classified by Susquehanna within Level 3 of the valuation hierarchy.
				Available-for-sale Securities
								Non-
								agency
						Other		Residential
						Structured		Mortgage-
				Equity		Financial		backed
				Securities		Products		Securities		Total
Balance at July 1, 2013				$	2,820	$	10,506	$	24,549	$	37,875
	Total gains or losses (realized/unrealized):
		Included in earnings:
			Other-than-temporary impairment (1)		0		0		0		0
		Included in other comprehensive income (before taxes)			1		938		(1,527)		(588)
Balance at September 30, 2013				$	2,821	$	11,444	$	23,022	$	37,287
Balance at July 1, 2012				$	3,159	$	8,462	$	4,288	$	15,909
	Total gains or losses (realized/unrealized):
		Included in earnings:
			Other-than-temporary impairment (1)		0		0		0		0
		Included in other comprehensive income (before taxes)			1		(70)		(201)		(270)
	Sales				0		0		0		0
Balance at September 30, 2012				$	3,160	$	8,392	$	4,087	$	15,639
Balance at January 1, 2013				$	3,156	$	9,550	$	26,800	$	39,506
	Total gains or losses (realized/unrealized):
		Included in earnings:
			Other-than-temporary impairment (1)		(97)		0		(388)		(485)
		Included in other comprehensive income (before taxes)			(238)		1,894		(3,390)		(1,734)
Balance at September 30, 2013				$	2,821	$	11,444	$	23,022	$	37,287
Balance at January 1, 2012				$	3,430	$	13,293	$	0	$	16,723
	Total gains or losses (realized/unrealized):
		Included in earnings:
			Other-than-temporary impairment (1)		(144)		0		3,092		2,948
		Included in other comprehensive income (before taxes)			(126)		(4,901)		(360)		(5,387)
	Sales				0		0		(18,782)		(18,782)
	Transfers into Level III				0		0		20,137		20,137
Balance at September 30, 2012				$	3,160	$	8,392	$	4,087	$	15,639
(1)	Included in noninterest income, net realized gain on sale of securities.

Susquehanna’s policy is to recognize transfers in and transfers out of Levels 1, 2, and 3 as of the end of a reporting period.

Assets Measured at Fair Value on a Nonrecurring Basis

Impaired loans

Impaired collateral dependent loans and other loans where the carrying value is based on the fair value of the underlying collateral less selling costs, such as residential mortgage loans charged off in accordance with regulatory guidance, are measured at fair value on a nonrecurring basis. The fair value of the underlying collateral is incorporated into the estimate of the impairment of a

50

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

loan. Most of Susquehanna’s impaired collateral dependent loans are secured by real estate. The value of the real estate collateral is determined through appraisals performed by third-party, licensed appraisers. As part of Susquehanna’s overall valuation process, management evaluates these third-party appraisals to ensure that they are representative of the exit prices in Susquehanna’s principal markets. Susquehanna considers the appraisals used in its impairment analysis to be Level 3 inputs. When the value of the real estate, less estimated selling costs, is less than the principal balance of the loan, a specific reserve is established. Impaired loans are reviewed at least quarterly for additional impairment, and reserves are adjusted accordingly.

Foreclosed Assets

Other real estate property acquired through foreclosure is recorded at the lower of its carrying value or the fair value of the related real estate collateral at the transfer date, less estimated selling costs. The value of the real estate collateral is determined through appraisals performed by third party licensed appraisers. As part of Susquehanna’s overall valuation process, management evaluates these third-party appraisals to ensure that they are representative of the exit prices in Susquehanna’s principal markets. Susquehanna considers the appraisals used in its impairment analysis to be Level 3 inputs.

	The following tables present assets measured at fair value on a nonrecurring basis at September 30, 2013 and December 31, 2012,
on the consolidated balance sheets and by the valuation hierarchy.
				Quoted
				Prices
				in Active		Significant
				Markets for		Other		Significant
				Identical		Observable		Unobservable
				Instruments		Inputs		Inputs
	Description	September 30, 2013		(Level 1)		(Level 2)		(Level 3)
	Impaired loans	$	73,649	$	0	$	0	$	73,649
	Foreclosed assets		17,760		0		0		17,760
		$	91,409	$	0	$	0	$	91,409
				Quoted
				Prices
				in Active		Significant
				Markets for		Other		Significant
				Identical		Observable		Unobservable
				Instruments		Inputs		Inputs
	Description	December 31, 2012		(Level 1)		(Level 2)		(Level 3)
	Impaired loans	$	65,731	$	0	$	0	$	65,731
	Foreclosed assets		26,245		0		0		26,245
		$	91,976	$	0	$	0	$	91,976

51

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

	The following table details the quantitative information about Level 3 fair value measurements:
		Fair Value at		Valuation		Range
Asset		September 30, 2013		Technique(s)	Unobservable Input	(Weighted Average)
Non-agency residential mortgage-				Discounted Cash Flow	Conditional repayment rate	10.6%
	backed securities	$	23,022		Loss severity	37.8%
					Conditional default rate	3.6%
Other structured financial products			11,444	Discounted Cash Flow	Credit default rates, call options and deferrals, waterfall structure, and covenants.	Varies by individual security, refer to Note 3
Other equity securities			2,821	Discounted Cash Flow	Cash flows from dividends and terminal value	0.2x - 1.5x
						(.8x)
Impaired loans			73,649	Discounted Cash Flow	Cash flows based upon current discount rates and terminal value	0.9% - 8.1%
						(3.7%)
Foreclosed assets			17,760	Discounted Cash Flow	Third party appraisals less estimated selling costs	0.0% - 100.0%
						(28.0%)

		Fair Value at		Valuation		Range
Asset		December 31, 2012		Technique(s)	Unobservable Input	(Weighted Average)
Non-agency residential mortgage-				Discounted Cash Flow	Conditional repayment rate	10.4%
	backed securities	$	26,800		Loss severity	43.8%
					Conditional default rate	3.6%
Other structured financial products			9,550	Discounted Cash Flow	Credit default rates, call options and deferrals, waterfall structure, and covenants.	Varies by individual security, refer to Note 3
Other equity securities			3,156	Discounted Cash Flow	Cash flows from dividends and terminal value	0.2x - 1.5x
						(0.9x)
Impaired loans			65,731	Discounted Cash Flow	Cash flows based upon current discount rates and terminal value	2.9% - 5.6%
						(4.2%)
Foreclosed assets			26,245	Discounted Cash Flow	Third party appraisals less estimated selling costs	0.0% - 100.0%
						(24.0%)

The significant unobservable inputs used in the fair value measurement of Susquehanna’s other structured financial products are conditional repayment rate, loss severity, and conditional default rate. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and directionally opposite change in the assumption used for repayment rate.

52

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

Additional Disclosures about Fair Value of Financial Instruments
	The following table represents the carrying amounts and estimated fair values of Susquehanna's financial instruments.  The
methods and assumptions used to estimate the fair value of each class of financial instruments are described above.
			September 30, 2013
			Carrying
			Amount		Fair Value		Level 1		Level 2		Level 3
	Financial assets:
		Cash and due from banks	$	377,730	$	377,730	$	377,730	$	0	$	0
		Short-term investments		77,729		77,729		0		77,729		0
		Investment securities		2,483,375		2,483,375		20,912		2,425,176		37,287
		Restricted investment in bank stocks		160,787		160,787		0		160,787		0
		Loans and leases		13,376,454		13,477,467		0		0		13,477,467
		Derivatives		22,936		22,936		0		22,936		0
	Financial liabilities:
		Deposits		12,721,685		12,702,818		0		12,702,818		0
		Short-term borrowings		688,456		688,456		0		688,456		0
		FHLB borrowings		1,593,272		1,593,362		0		1,593,362		0
		Long-term debt		457,804		463,940		0		463,940		0
		Derivatives		54,712		54,712		0		54,712		0
			December 31, 2012
			Carrying
			Amount		Fair Value		Level 1		Level 2		Level 3
	Financial assets:
		Cash and due from banks	$	277,042	$	277,042	$	277,042	$	0	$	0
		Short-term investments		119,176		119,176		0		119,176		0
		Investment securities		2,577,901		2,577,901		21,266		2,517,129		39,506
		Restricted investment in bank stocks		152,434		152,434		0		152,434		0
		Loans and leases		12,894,741		12,954,918		0		0		12,954,918
		Derivatives		25,915		25,915		0		25,915		0
	Financial liabilities:
		Deposits		12,580,046		12,544,069		0		12,544,069		0
		Short-term borrowings		817,577		817,577		0		817,577		0
		FHLB borrowings		1,199,062		1,200,358		0		1,200,358		0
		Long-term debt		513,401		512,632		0		512,632		0
		Derivatives		72,126		72,126		0		72,126		0

53

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Amounts in thousands, except as noted and per share)

NOTE 16. Subsequent Event

On October 4, 2013, Susquehanna completed its previously announced branch consolidation plan.  This involved the consolidation of 13 branch locations into other Susquehanna branches, with one additional branch to be closed on December 31, 2013. The total amount of costs incurred in connection with the consolidation process approximated $7.2 million, net of liabilities currently recognized, and will be recognized in the fourth quarter of 2013. Approximately $2.7 million of the total charge will be incurred in connection with a shortened useful life of premises and equipment and approximately $4.5 million of the total charge will be incurred for contract termination costs. The gross cash payments that Susquehanna expects to make will be between $7.0 and $9.0 million.

54

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s discussion and analysis of the significant changes in the consolidated results of operations, financial condition, and cash flows of Susquehanna Bancshares, Inc. and its subsidiaries is set forth below for the periods indicated.  Unless the context requires otherwise, the terms “Susquehanna”, “we”, “us”, and “our” refer to Susquehanna Bancshares, Inc. and its subsidiaries.

Certain statements in this report may be considered to be "forward-looking statements" as that term is defined in the U.S. Private Securities Litigation Reform Act of 1995, such as statements that include the words "expect," "estimate," "project," "anticipate," "should," "intend," "probability," "risk," "target," "objective" and similar expressions or variations on such expressions. In particular, this document includes forward-looking statements relating, but not limited to, general economic conditions; the impact of new regulations on our business; our potential exposures to various types of market risks, such as interest rate risk and credit risk; expectations regarding future acquisitions; whether our allowance for loan and lease losses is adequate to meet probable loan and lease losses; the expected values of assets and liabilities acquired in connection with the Tower merger; the improvement in the credit quality of our loan portfolio; our ability to maintain market share and monitor and manage our portfolios; our ability to evaluate loan guarantors; our ability to offset loan prepayment penalties through decreased interest expense on FHLB borrowings; our ability to achieve loan growth; our ability to maintain sufficient liquidity; our ability to manage credit quality; and our ability to achieve our 2013 financial goals. Such statements are subject to certain risks and uncertainties. For example, certain of the market risk disclosures are dependent on choices about essential model characteristics and assumptions and are subject to various limitations. By their nature, certain of the market-risk disclosures are only estimates and could be materially different from what actually occurs in the future. As a result, actual income gains and losses could materially differ from those that have been estimated. Other factors that could cause actual results to differ materially from those estimated by the forward-looking statements contained in this document include, but are not limited to:

·adverse changes in our loan and lease portfolios and the resulting credit-risk-related losses and expenses;

·adverse changes in regional real estate values;

·interest rate fluctuations which could increase our cost of funds or decrease our yield on earning assets and therefore reduce our net interest income;

·decreases in our loan and lease quality and origination volume;

·the adequacy of loss reserves;

·impairment of goodwill or other assets;

·the loss of certain key officers, which could adversely impact our business;

·continued relationships with major customers;

·the ability to continue to grow our business internally and through acquisition and successful integration of bank and non-bank entities while controlling our costs;

·adverse international, national and regional economic and business conditions;

·compliance with laws and regulatory requirements of federal and state agencies;

·competition from other financial institutions in originating loans, attracting deposits, and providing various financial services that may affect our profitability;

·the ability to hedge certain risks effectively and economically;

·our ability to effectively implement technology driven products and services;

·changes in consumer confidence, spending and savings habits relative to the bank and non-bank financial services we provide;

55

·changes in legal or regulatory requirements or the results of regulatory examinations that could adversely impact our business and financial condition and restrict growth;

·the impact of federal laws and related rules and regulations on our business operations and competitiveness;

·the effects of and changes in trade, monetary and fiscal policies, and laws, including interest rate policies of the Federal Reserve Board;

·the effects of and changes in the rate of Federal Deposit Insurance Corporation (“FDIC”) premiums; and

·our success in managing the risks involved in the foregoing.

We encourage readers of this report to understand forward-looking statements to be strategic objectives rather than absolute targets of future performance. Forward-looking statements speak only as of the date they are made. We do not intend to update publicly any forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events except as required by law.

The following discussion and analysis, the purpose of which is to provide investors and others with information that we believe to be necessary for an understanding of our financial condition, changes in financial condition, and results of operations, should be read in conjunction with the financial statements, notes, and other information contained in this document.

The following information refers to Susquehanna Bancshares, Inc. and its wholly owned subsidiaries: Boston Service Company, Inc. (t/a Hann Financial Service Corporation) (“Hann”), Susquehanna Bank and subsidiaries, Valley Forge Asset Management Corp. (“VFAM”), Stratton Management Company and subsidiary (“Stratton”), and The Addis Group, LLC (“Addis”).

Availability of Information

Our web-site address is www.susquehanna.net. We make available free of charge, through the Investor Relations section of our web site, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. We include our web-site address in this report as an inactive textual reference only.  Information contained on our website is not incorporated into and does not constitute part of this report.

Executive Overview

Critical Accounting Policies

        Susquehanna’s significant accounting policies are defined in Note 1 to the Consolidated Financial Statements included in its 2012  Form 10-K, and in Note 1 to the Consolidated Financial Statements included in this report. The preparation of the Consolidated Financial Statements is in accordance with accounting principles generally accepted in the United States (“GAAP”).  Management is required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and to disclose contingent assets and liabilities. Actual results could differ from those estimates.  Management has identified accounting for: (i) the allowance for loan and lease losses; (ii) fair value measurements for valuation of financial instruments; (iii) valuation of goodwill; and, (iv) income taxes, as Susquehanna’s most critical accounting policies and estimates in that they are important to the portrayal of Susquehanna’s financial condition and results.  These accounting policies, including the nature of the estimates and types of assumptions used, are described throughout the Consolidated Financial Statements, accompanying footnotes, and Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Recent Legislation

        In July 2013, the Federal Reserve Board, Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation approved final rules to implement the Basel III capital framework. The rules will be effective on January 1, 2014 and phased-in over a multiple year period becoming fully effective on January 1, 2019. The new capital rules call for higher quality capital with higher minimum capital level requirements. Consistent with the international Basel framework, the rules include a new minimum ratio of common equity tier I capital to risk-weighted assets of 4.5 percent, and a common equity tier I capital conservation buffer of 2.5 percent of risk-weighted assets.  The rules also raise the minimum ratio of tier I capital to risk-weighted assets from 4.0 percent to 6.0 percent and includes a minimum leverage ratio of 4.0 percent.  Management has evaluated these new rules and anticipates Susquehanna would have had sufficient capital to meet the increased requirements at September 30, 2013.

56

Recent Developments

       On October 4, 2013, Susquehanna completed its previously announced branch consolidation plan. This involved the consolidation of 13 branch locations into other Susquehanna branches, with one additional branch to be closed on December 31, 2013.  The total amount incurred in connection with the consolidation process approximated $7.2 million, net of liabilities currently recognized, and will be recognized in the fourth quarter of 2013. Approximately $2.7 million of the total charge will be incurred in connection with a shortened useful life of premises and equipment and approximately $4.5 million of the total charge will be incurred for contract termination costs. The gross cash payments that Susquehanna expects to make will be $7.0 to $9.0 million.

Summary of Performance

        Susquehanna’s net income available to common shareholders was $44.3 million, or $0.24  per diluted share, for the three months ended September 30, 2013, an increase of $7.6 million when compared to $36.7 million, or $0.20  per diluted share, for the three months ended September 30, 2012. The $7.6 million increase in net income for the three months ended September 30, 2013 is due to a $11.0 million decrease in provision for loan and lease losses, and a $5.2 million decrease in non-interest expense, partially offset by a decrease of $2.3 million in non-interest income, and a $3.1 million increase in income tax expense.  Susquehanna’s net income available to common shareholders was $132.3 million, or $0.70  per diluted share, for the nine months ended September 30, 2013, an increase of $34.3 million when compared to $98.0 million, or $0.54 per diluted share, for the nine months ended September 30, 2012. The $34.3 million increase in net income for the nine months ended September 30, 2013 is due to a $7.3 million increase in net interest income, a $22.0 million decrease in provision for loan and lease losses, a $10.1 million increase in non-interest income, and a decrease of $9.6 million in non-interest expense, partially offset by an increase of $14.6 million in income tax expense.

Our 2013 financial goals are as follows:
	Table 1
	Key Susquehanna Financial Targets
		Updated as of	Original as of
		September 30, 2013	January 1, 2013
	Net interest margin (FTE)	3.80%	3.90%
	Loan growth	4.0%	5.0%
	Deposit growth	2.0%	6.0%
	Noninterest income growth	5.0%	8.0%
	Noninterest expense growth	-2.5%	-2.0%
	Effective tax rate	31.0%	32.0%

Acquisitions

On February 17, 2012, we completed the acquisition of Tower Bancorp, Inc. (“Tower”), a Pennsylvania chartered bank holding company based in Harrisburg, Pennsylvania with approximately $2.5 billion of assets, through a merger of Tower with and into Susquehanna.  In connection with the Tower merger, Tower’s wholly-owned banking subsidiary, Graystone Tower Bank, was merged into Susquehanna’s wholly-owned banking subsidiary Susquehanna Bank, with Susquehanna Bank being the surviving institution.  The acquisition of Tower enhances Susquehanna’s footprint in Pennsylvania and Maryland.  The acquisition was accounted for under the acquisition method.

57

Results of Operations
Table 2
Summary of Third Quarter 2013 Compared to Third Quarter 2012, and Nine Months Ended September 30, 2013 Compared to Nine Months Ended September 30, 2012
		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2013		2012		% Change		2013		2012		% Change
Net income		$	44,291	$	36,732	20.6	%	$	132,338	$	97,998	35.0	%
Net interest income			145,949		149,142	(2.1)			443,252		435,934	1.7
Provision for loan and lease losses			5,000		16,000	(68.8)			29,000		51,000	(43.1)
Non-interest income			41,343		43,661	(5.3)			133,063		122,987	8.2
Non-interest expense			117,701		122,910	(4.2)			355,168		364,740	(2.6)
Non-interest expense excluding
	merger-related expenses and loss
	on extinguishment of debt		117,701		115,959	1.5			355,168		342,992	3.5

Table 3
Key Susquehanna Financial Measures
		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2013			2012			2013			2012
	Diluted Earnings per Common Share	$	0.24		$	0.20		$	0.70		$	0.54
	Return on Average Assets		0.96	%		0.81	%		0.98	%		0.75	%
	Return on Average Shareholders' Equity		6.65	%		5.70	%		6.71	%		5.27	%
	Return on Average Tangible Shareholders' Equity (1)		13.67	%		12.41	%		13.95	%		11.33	%
	Efficiency Ratio (1)(2)		61.62	%		58.98	%		60.43	%		60.15	%
	Net Interest Margin		3.72	%		3.92	%		3.85	%		3.99	%
(1)	Supplemental Reporting of Non-GAAP-based Financial Measurements.
(2)	Adjusted for merger-related expenses.

Return on average tangible equity is a non-GAAP-based financial measure calculated using non-GAAP amounts.  The most directly related comparable measure is return on average shareholders’ equity, which is calculated using GAAP-based amounts.  We calculate return on average tangible shareholders’ equity by excluding the balance of intangible assets and their related amortization expense from our calculation of return on average shareholders’ equity.  Management uses the return on average tangible shareholders’ equity in order to evaluate its business performance relative to the tangible capital supporting the ongoing business.  Management believes that this is a better measure of our performance.  In addition, this is consistent with the treatment by bank regulatory agencies, which excludes goodwill and other intangible assets from the calculation of risk-based capital ratios.  A reconciliation of return on average shareholders’ equity to return on average tangible shareholders’ equity is set forth as part of Table 4 below.

58

Table 4
Reconciliation of Non-GAAP Measures
			Three Months Ended						Nine Months Ended
			September 30,						September 30,
			2013			2012			2013			2012
Tangible Book Value per Common Share
End of period balance sheet data
	Shareholders' equity		$	2,679,348		$	2,584,682		$	2,679,348		$	2,584,682
	Goodwill and other intangible assets			(1,309,105)			(1,313,310)			(1,309,105)			(1,313,310)
		Tangible common equity (numerator)	$	1,370,243		$	1,271,372		$	1,370,243		$	1,271,372
Common shares outstanding (denominator)				187,225			186,465			187,225			186,465
	Tangible book value per common share		$	7.32		$	6.82		$	7.32		$	6.82
Return on Average Tangible Shareholders' Equity
Return on average shareholders' equity (GAAP basis)				6.65	%		5.70	%		6.71	%		5.27	%
Effect of excluding average intangible assets and related
	amortization			7.02	%		6.71	%		7.24	%		6.06	%
	Return on average tangible shareholders' equity			13.67	%		12.41	%		13.95	%		11.33	%
Efficiency Ratio
Other expense			$	117,701		$	122,910		$	355,168		$	364,740
Less:	Merger related expenses			0			(1,500)			0			(16,297)
	Loss on extinguishment of debt			0			(5,451)			0			(5,451)
Noninterest operating expense (numerator)			$	117,701		$	115,959		$	355,168		$	342,992
Taxable-equivalent net interest income			$	149,683		$	152,948		$	454,678		$	447,200
Other income				41,343			43,661			133,063			122,987
	Denominator		$	191,026		$	196,609		$	587,741		$	570,187
	Efficiency ratio			61.62	%		58.98	%		60.43	%		60.15	%

59

Table 5
Distribution of Assets, Liabilities and Shareholders' Equity
Interest Rates and Interest Differential - Tax Equivalent Basis
			For the Three Month Period Ended						For the Three Month Period Ended
			September 30, 2013						September 30, 2012
			Average					Average
			Balance		Interest		Rate (%)	Balance		Interest		Rate (%)
			(Dollars in thousands)
Assets
Short-term investments			$	85,503	$	16	0.07	$	112,830	$	36	0.13
Investment securities:
		Taxable		2,191,743		11,937	2.16		2,421,414		13,434	2.21
		Tax-advantaged		392,469		5,450	5.51		390,316		5,568	5.68
	Total investment securities			2,584,212		17,387	2.67		2,811,730		19,002	2.69
Loans and leases, (net):
		Taxable		12,888,591		152,275	4.69		12,222,031		160,532	5.23
		Tax-advantaged		401,922		5,133	5.07		390,446		5,305	5.41
	Total loans and leases			13,290,513		157,408	4.70		12,612,477		165,837	5.23
Total interest-earning assets				15,960,228		174,811	4.35		15,537,037		184,875	4.73
Allowance for loan and lease losses				(177,853)					(189,406)
Other noninterest-earning assets				2,476,607					2,673,477
Total assets			$	18,258,982				$	18,021,108
Liabilities
Deposits:
Interest-bearing demand
		Interest-bearing demand	$	5,936,693	$	3,904	0.26	$	5,537,196	$	4,817	0.35
		Savings		1,075,734		286	0.11		1,002,981		274	0.11
		Time		3,870,542		10,229	1.05		4,110,685		12,085	1.17
Short-term borrowings				758,079		2,242	1.17		748,841		2,206	1.17
FHLB borrowings				1,285,276		4,199	1.30		1,072,555		3,553	1.32
Long-term debt				475,655		4,268	3.56		727,382		8,992	4.92
Total interest-bearing liabilities				13,401,979		25,128	0.74		13,199,640		31,927	0.96
Demand deposits				1,911,053					1,937,835
Other liabilities				303,144					321,541
Total liabilities				15,616,176					15,459,016
Equity				2,642,806					2,562,092
Total liabilities & shareholders' equity			$	18,258,982				$	18,021,108
Net interest income / yield on
		average earning assets				149,683	3.72				152,948	3.92
Taxable equivalent adjustment						(3,734)					(3,806)
Net interest income - as reported					$	145,949				$	149,142

60

Table 5
Distribution of Assets, Liabilities and Shareholders' Equity
Interest Rates and Interest Differential - Tax Equivalent Basis
			For the Nine Month Period Ended					For the Nine Month Period Ended
			September 30, 2013					September 30, 2012
			Average					Average
			Balance		Interest		Rate (%)	Balance		Interest		Rate (%)
			(Dollars in thousands)
Assets
Short-term investments			$	100,443	$	87	0.12	$	106,780	$	101	0.13
Investment securities:
		Taxable		2,166,932		34,193	2.11		2,306,402		41,277	2.39
		Tax-advantaged		396,930		16,515	5.56		381,840		16,927	5.92
	Total investment securities			2,563,862		50,708	2.64		2,688,242		58,204	2.89
Loans and leases, (net):
		Taxable		12,695,055		465,689	4.90		11,813,477		468,563	5.30
		Tax-advantaged		416,270		15,830	5.08		372,014		15,262	5.48
	Total loans and leases			13,111,325		481,519	4.91		12,185,491		483,825	5.30
Total interest-earning assets				15,775,630		532,314	4.51		14,980,513		542,130	4.83
Allowance for loan and lease losses				(180,652)					(190,265)
Other noninterest-earning assets				2,526,382					2,577,332
Total assets			$	18,121,360				$	17,367,580
Liabilities
Deposits:
		Interest-bearing demand	$	5,938,605	$	12,746	0.29	$	5,336,552	$	15,826	0.40
		Savings		1,068,446		858	0.11		979,190		936	0.13
		Time		3,847,294		33,115	1.15		3,974,635		35,517	1.19
Short-term borrowings				767,911		6,548	1.14		705,916		6,507	1.23
FHLB borrowings				1,161,305		11,626	1.34		1,046,809		9,970	1.27
Long-term debt				493,358		12,743	3.45		695,980		26,174	5.02
Total interest-bearing liabilities				13,276,919		77,636	0.78		12,739,082		94,930	1.00
Demand deposits				1,913,701					1,849,445
Other liabilities				295,489					296,207
Total liabilities				15,486,109					14,884,734
Equity				2,635,251					2,482,846
Total liabilities & shareholders' equity			$	18,121,360				$	17,367,580
Net interest income / yield on
	average earning assets					454,678	3.85				447,200	3.99
Taxable equivalent adjustment						(11,426)					(11,266)
Net interest income - as reported					$	443,252				$	435,934

61

Table 6
Changes in Net Interest Income - Tax Equivalent Basis
		Three months ended September 30, 2013						Nine months ended September 30, 2013
		versus September 30, 2012						versus September 30, 2012
		Increase (Decrease)						Increase (Decrease)
		Due to Change in (1)						Due to Change in (1)
		Average		Average				Average		Average
		Volume		Rate		Total		Volume		Rate		Total
		(Dollars in thousands)
Interest Income
Other short-term investments		$	(8)	$	(13)	$	(21)	$	(6)	$	(8)	$	(14)
Investment securities:
	Taxable		(1,225)		(272)		(1,497)		(2,407)		(4,677)		(7,084)
	Tax-advantaged		33		(151)		(118)		647		(1,059)		(412)
Total investment securities			(1,192)		(423)		(1,615)		(1,760)		(5,736)		(7,496)
Loans (net of unearned income):
	Taxable		8,604		(16,860)		(8,256)		33,434		(36,308)		(2,874)
	Tax-advantaged		158		(330)		(172)		1,724		(1,156)		568
Total loans			8,762		(17,190)		(8,428)		35,158		(37,464)		(2,306)
Total interest-earning assets		$	7,562	$	(17,626)	$	(10,064)	$	33,392	$	(43,208)	$	(9,816)
Interest Expense
Deposits:
	Interest-bearing demand	$	334	$	(1,247)	$	(913)	$	1,638	$	(4,718)	$	(3,080)
	Savings		20		(8)		12		80		(158)		(78)
	Time		(669)		(1,187)		(1,856)		(1,133)		(1,269)		(2,402)
Short-term borrowings			32		4		36		545		(504)		41
FHLB borrowings			705		(59)		646		1,122		534		1,656
Long-term debt			(2,627)		(2,097)		(4,724)		(6,477)		(6,954)		(13,431)
Total interest-bearing liabilities			(2,205)		(4,594)		(6,799)		(4,225)		(13,069)		(17,294)
Net Interest Income		$	9,767	$	(13,032)	$	(3,265)	$	37,617	$	(30,139)	$	7,478
(1)	Changes that are due in part to volume and in part to rate are allocated in proportion to their relationship to the amounts of changes directly to volume and rate.

Net Interest Income-Taxable Equivalent Basis

Our major source of operating revenues is net interest income, which decreased 2.1% to $145.9 million for the third quarter of 2013, as compared to $149.1 million for the same period in 2012. Net interest income as a percentage of net interest income plus noninterest income was 77.9% and 77.3%, respectively, for each of the quarters ended September 30, 2013 and September 30, 2012. For the nine month period ended September 30, 2013, net interest income increased $7.3 million, or 1.7%, to $443.3 million, compared to $435.9 million recorded in the same period of 2012. Net interest income as a percentage of net interest income plus noninterest income was 76.9% and 78.0%, respectively, for the nine month periods ended September 30, 2013 and 2012.

Net interest income is the income that remains after deducting, from total income generated by earning assets, the interest expense attributable to the cost of the funds required to support earning assets. Income from earning assets includes income from loans, investment securities, and short-term investments. The amount of interest income is dependent upon many factors, including the volume of earning assets, the general level of interest rates, the dynamics of the change in interest rates, the levels of non-performing loans, and accretion of fair value adjustments on purchased loans. The cost of funds varies with the amount of funds necessary to

62

support earning assets, the rates paid to attract and hold deposits, the rates paid on borrowed funds, amortization of core deposit intangibles, accretion of fair value adjustments on acquired deposits, and the levels of noninterest-bearing demand deposits and equity capital.

Table 5 presents average balances, taxable equivalent interest income and expense, and yields earned or paid on these assets and liabilities. For purposes of calculating taxable equivalent interest income, tax-exempt interest has been adjusted using a marginal tax rate of 35% in order to equate the yield to that of taxable interest rates.

The decrease of $3.3 million in our taxable equivalent net interest income for the third quarter of 2013, as compared to the third quarter of 2012, was primarily the result of a 20 basis point decrease in net interest margin.  The yield on interest-earning assets declined by 38 basis points, and the rate paid on interest-bearing liabilities declined by 22 basis points.  The greater decline in yield versus rate paid results from a 6 basis point decrease in the recognition of purchase accounting benefit from the loan portfolio, plus the decline in yield earned on newly originated interest-earning assets versus matured interest-earning assets being greater than the decline in rate paid on newly originated interest-bearing liabilities versus matured interest-bearing liabilities.  The lower yields on newly originated loan assets results from a highly competitive environment, where multiple banks within our footprint are offering desirable rates and terms for quality loans.

The increase of $7.5 million in our taxable equivalent net interest income for the first nine months of 2013, as compared to the first nine months of 2012, was primarily the result of $0.8 billion increase in the average interest-earning assets, due mainly to the Tower acquisition, having a greater impact than the $0.5 billion increase in average interest-bearing liabilities.  These increases in average volume were partially offset by an 14 basis point decline in net interest margin, as the yield earned on interest-earning assets declined 32 basis points, and the rate paid on interest-bearing liabilities declined 22 basis points, due to the decline in yield earned on newly originated interest-earning assets versus matured interest-earning assets, partially offset by a 7 basis point increase in purchase accounting benefit from the loan portfolio, being greater than the decline in rate paid on newly originated interest-bearing liabilities versus matured interest-bearing liabilities.

We expect the purchase accounting benefit from the loan portfolio to continue into 2014, but would note that the timing of this benefit is not certain due to the behavior of customers in the current interest rate environment.

Variances do occur in the net interest margin, as an exact repricing of assets and liabilities is not possible.  A further explanation of the impact of asset and liability repricing is found in Item 3, “Quantitative and Qualitative Disclosures About Market Risk.”

Provision and Allowance for Loan and Lease Losses

The provision for loan and lease losses is the expense necessary to maintain the allowance for loan and lease losses at a level appropriate to absorb management’s estimate of probable incurred losses in the loan and lease portfolio. Our provision for loan and lease losses is based upon management’s quarterly review of the loan and lease portfolio. The purpose of the review is to assess loan quality, identify impaired loans and leases, analyze delinquencies, ascertain loan and lease growth, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets we serve.

Net charge-offs for the third quarter of 2013 decreased to $16.9 million, or 0.50% of average loans and leases, when compared to net charge-offs for the third quarter of 2012 of $19.7 million, or 0.62% of average loans and leases. Net charge-offs for the nine months ended September 30, 2013 decreased to $46.3 million, or 0.47% of average loans and leases, when compared to net charge-offs for the nine months ended September 30, 2012 of $52.2 million, or 0.57% of average loans and leases. Nonaccrual loans declined significantly during this period, from $118.4 million at September 30, 2012 to $102.0 million at September 30, 2013. Additionally, non-performing assets comprised of non-accrual loans plus foreclosed real estate, has declined from $147.1 million, or 1.16% of total loans and leases at September 30, 2012, to $119.7 million, or 0.89% of total loans and leases at September 30, 2013.  As a result, we decreased the qualitative adjustments related to economic uncertainty.  This decrease combined with the improving credit trends supported the decrease in the provision for loan and lease losses from $51.0 million for the first nine months of 2012 to $29.0 million for the first nine months of 2013. In addition, on a linked-quarter basis, net charge-offs for the second quarter of 2013 were $9.8 million, and net charge-offs for the first quarter of 2013 were $19.6 million.

The allowance for loan and lease losses was 1.25% of period-end loans and leases, or $166.7 million, at September 30, 2013; 1.43% of period-end loans and leases, or $184.0 million, at December 31, 2012; and 1.47% of period-end loans and leases, or $186.9 million, at September 30, 2012. The allowance for loan and lease losses for Originated loans was 1.40% of period-end loans and leases, or $163.2 million, at September 30, 2013; 1.70% of period-end loans and leases, or $182.9 million, at December 31, 2012; and 1.78% of period-end loans and leases, or $185.2 million, at September 30, 2012.

Determining the level of the allowance for probable loan and lease losses at any given point in time is difficult, particularly during uncertain economic periods. We must make estimates using assumptions and information that is often subjective and changing

63

rapidly. The review of the loan and lease portfolios is a continuing process in light of a changing economy and the dynamics of the banking and regulatory environment. In our opinion, the allowance for loan and lease losses is appropriate to meet probable incurred loan and lease losses at September 30, 2013. There can be no assurance, however, that we will not sustain loan and lease losses in future periods greater than the size of the allowance at September 30, 2013.

Table 7
Provision and Allowance for Loan and Lease Losses
				Three Months Ended				Nine Months Ended
				September 30				September 30
				2013		2012		2013		2012
				(Dollars in thousands)
	Balance - beginning of period			$	178,594	$	190,628	$	184,020	$	188,100
		Additions			5,000		16,000		29,000		51,000
		Charge-offs:
			Commercial, financial, and agricultural		(5,892)		(7,003)		(26,758)		(20,572)
			Real estate - construction		(8,103)		(3,280)		(14,036)		(12,795)
			Real estate secured - residential		(4,151)		(2,896)		(9,771)		(10,338)
			Real estate secured - commercial		(6,043)		(9,833)		(11,488)		(32,910)
			Consumer		(1,051)		(616)		(2,397)		(2,341)
			Leases		(694)		(955)		(3,015)		(2,946)
		Total charge-offs			(25,934)		(24,583)		(67,465)		(81,902)
		Recoveries:
			Commercial, financial, and agricultural		2,161		3,246		6,197		7,562
			Real estate - construction		1,599		371		3,786		2,069
			Real estate secured - residential		627		426		1,879		1,663
			Real estate secured - commercial		4,036		394		6,841		16,715
			Consumer		325		168		886		912
			Leases		332		247		1,596		778
		Total recoveries			9,080		4,852		21,185		29,699
		Net charge-offs			(16,854)		(19,731)		(46,280)		(52,203)
	Balance - end of period			$	166,740	$	186,897	$	166,740	$	186,897
	Average loans and leases outstanding			$	13,290,513	$	12,612,477	$	13,111,325	$	12,185,491
	Period-end loans and leases				13,376,454		12,675,607		13,376,454		12,675,607
	Net charge-offs as a percentage of average loans
		and leases (annualized)			0.50%		0.62%		0.47%		0.57%
	Allowance as a percentage of period-end loans
		and leases			1.25%		1.47%		1.25%		1.47%

64

Noninterest Income
	The following table presents a breakdown of Susquehanna's noninterest income.
Table 8
Noninterest Income
						% Change						% Change
		Three Months				2013		Nine Months				2013
		Ended September 30,				vs.		Ended September 30,				vs.
		2013		2012		2012		2013		2012		2012
		Dollars in thousands
Service charges on deposit accounts		$	9,514	$	9,013	5.6	%	$	27,533	$	25,270	9.0	%
Vehicle origination and servicing fees			2,907		2,470	17.7			8,668		6,620	30.9
Wealth management commissions and fees			12,606		11,923	5.7			38,285		35,823	6.9
Commissions on property and casualty
	insurance sales		3,872		3,158	22.6			12,774		12,145	5.2
Other commissions and fees			5,276		5,387	(2.1)			17,199		14,830	16.0
Income from bank-owned life insurance			1,493		1,726	(13.5)			4,521		4,868	(7.1)
Mortgage banking revenue			2,237		5,113	(56.2)			10,345		12,969	(20.2)
Net realized gain on sales of securities			2		31	(93.5)			(51)		1,633	(103.1)
Other			3,436		4,840	(29.0)			13,789		8,829	56.2
	Total noninterest income	$	41,343	$	43,661	(5.3)		$	133,063	$	122,987	8.2

Third Quarter 2013 Compared to Third Quarter 2012

Noninterest income, as a percentage of net interest income plus noninterest income, was 22.1% for the third quarter of 2013 and 22.7% for the third quarter of 2012.

Noninterest income decreased $2.3 million, or 5.3%, for the third quarter of 2013, as compared to the third quarter of 2012. This net decrease was primarily the result of the following:

·Increased wealth management commissions and fees of $0.7 million;

·Increased commissions on property and casualty insurance sales of $0.7 million;

·Decreased mortgage banking revenue of $2.9 million; and,

·Decreased other  of $1.4 million.

Wealth management commissions and fees. The 5.7% increase primarily is the result of increased fees related to the increased volume of assets under management.

Commissions on property and casualty insurance sales.  The 22.6% increase results from increased volume at our Addis subsidiary, as well as higher premium rates from their carriers.

Mortgage banking revenue.  The 56.2% decrease is the result of declining margins on sales.  Premiums paid by the secondary market have contracted industry wide as mortgage interest rates have increased over the past twelve months.

Other.  The 29.0% decrease results primarily from $2.0 million decrease in gain on sale of Other Real Estate Owned.

Nine months ended September 30, 2013 compared to Nine Months ended September 30, 2012

65

Noninterest income, as a percentage of net interest income plus noninterest income, was 23.1% for the nine-month period of 2013, and 22.0% for the nine-month period of 2012.

Noninterest income increased $10.1 million, or 8.2%, for the nine-month period of 2013, as compared to the nine-month period of 2012. This net increase was primarily the result of the following:

·Increased service charges on deposit accounts of $2.3 million;

·Increased vehicle origination and servicing fees of $2.0 million;

·Increased wealth management commissions and fees of $2.5 million;

·Increased other commissions and fees of $2.4 million;

·Decreased mortgage banking revenue of $2.6 million;

·Decreased net realized gain on sale of securities of $1.7 million; and,

·Increased other  of $5.0 million.

Service charges on deposit account. The 9.0% increase is primarily the result of recognizing a full nine months, in 2013, of service charges on accounts acquired in the Tower transaction, compared to two and one-half quarters in 2012.

Vehicle origination and servicing fees. The 30.9% increase is the result of lease production at our Hann subsidiary increasing due to expanded territories.

Wealth management commissions and fees. The 6.9% increase primarily is the result of increased fees related to the acquisition of Tower trust accounts.

Other commissions and fees.  The 16.0% increase is primarily the result of increased interest rate swap fees from our service to qualified customers enabling them to better manage their interest rate risk.

Mortgage banking revenue.  The 20.2% decrease is the result of lower premiums received on the sales.

Other.  The 56.2% decrease resulted primarily from a one-time insurance death benefit of $2.7 million; $1.0 million increase on gain from sale of Small Business Administration loans; and, a $1.9 million increase in miscellaneous income.

66

Noninterest Expense
	The following table presents a breakdown of Susquehanna's noninterest expense.
Table 9
Noninterest Expense
						% Change						% Change
		Three Months				2013		Nine Months				2013
		Ended September 30,				vs.		Ended September 30,				vs.
		2013		2012		2012		2013		2012		2012
		Dollars in thousands
Salaries and employee benefits		$	61,879	$	62,236	(0.6)	%	$	191,801	$	184,718	3.8	%
Occupancy			11,352		11,350	0			33,721		33,886	(0.5)
Furniture and equipment			3,661		3,823	(4.2)			10,986		11,749	(6.5)
Professional and technology services			7,173		4,916	45.9			18,733		14,591	28.4
Advertising and marketing			3,092		2,947	4.9			8,664		9,288	(6.7)
FDIC insurance			5,421		5,275	2.8			13,760		15,222	(9.6)
Legal fees			1,774		2,012	(11.8)			5,454		5,972	(8.7)
Amortization of intangible assets			2,502		3,337	(25.0)			8,823		9,253	(4.6)
Vehicle lease disposal			1,193		1,401	(14.8)			3,796		4,981	(23.8)
Other			19,654		18,662	5.3			59,430		53,332	11.4
			117,701		115,959	1.5			355,168		342,992	3.5
Merger related			0		1,500	(100.0)			0		16,297	(100.0)
Loss on extinguishment of debt			0		5,451	(100.0)			0		5,451	(100.0)
	Total noninterest expenses	$	117,701	$	122,910	(4.2)		$	355,168	$	364,740	(2.6)

Third Quarter 2013 Compared to Third Quarter 2012

Noninterest expenses, excluding merger-related costs and loss on extinguishment of debt, increased $1.7 million, or 1.5%, from $116.0 million for the third quarter of 2012, to $117.7 million for the third quarter of 2013. This net increase was primarily the result of:

·Increased professional and technology services of $2.3 million;

Professional and technology services.  The 45.9% increase is the result of increased consulting, audits and examinations, and data processing services.  Certain consulting expenses are related to continued investments in enterprise risk management, stress testing, and technology to comply with recent changes in regulations.

Nine Months ended September 30, 2013 Compared to Nine Months ended September 30, 2012

Noninterest expenses, excluding merger-related costs and loss on extinguishment of debt, increased $12.2 million, or 3.5%, from $343.0 million for the nine-month period of 2012, to $355.2 million for the nine-month period of 2013. This net increase was primarily the result of:

·Increased salaries and employee benefits of $7.1 million;

·Increased professional and technology services of $4.1 million;

·Decreased FDIC insurance of $1.5 million;

·Decreased vehicle lease disposal of $1.2 million: and,

·Increased other noninterest expense of $6.1 million.

67

Salaries and employee benefits.  The 3.8% increase is the result of recognizing a full three quarters, in 2013, of salary and benefit expense on employees acquired in the Tower transaction, compared to two and one-half quarters in 2012, and annual merit increases.

Professional and technology services.  The 28.4% increase is the result of increased consulting, audits and examinations, and data processing services.  Certain consulting expenses are related to continued investments in enterprise risk management, stress testing, and technology to comply with recent changes in regulations.

FDIC insurance.  The 9.6% decrease is the result of increasingly positive earnings and credit factors, and one-time refunds of prior period expense.

Vehicle lease disposal.  The 23.8% decrease is the result of lower volumes of vehicles coming off lease with lower turn-in ratios.

Other non-interest expenses.  The 11.4% increase is primarily the result of increased expenses relating to computer software maintenance and amortization, employee welfare, operating risk loss, and Pennsylvania shares tax, resulting from the Tower acquisition in February 2012.

Income Taxes

Our effective tax rate for the three and nine month reporting period ended September 30, 2013 was 31.4% and 31.1%, respectively.  Our effective tax rate for the three and nine month reporting period ended September 30, 2012 was 31.8% and 31.6%, respectively.  The decrease in tax rate was due to the amount of tax-advantaged income relative to total income for the three and nine months ended September 30, 2013, as compared to the tax-advantaged income relative to total income for the three and nine months ended September 30, 2012.  The estimated annual effective rates for the reporting periods ended September 30, 2013 and September 30, 2012 were impacted by the level of permanent differences, including tax-advantaged income, resulting in an effective rate below statutory rates for the interim reporting periods.

Financial Condition
Table 10
Summary of September 30, 2013 Compared to December 31, 2012
		September 30,		December 31,
		2013		2012		% Change
	Total assets	$	18,481,150	$	18,037,667	2.5	%
	Investment securities available for sale		2,483,375		2,577,901	(3.7)
	Loans and leases		13,376,454		12,894,741	3.7
	Deposits		12,721,685		12,580,046	1.1
	Shareholders' equity		2,679,348		2,595,909	3.2
	Book value per common share		14.31		13.92	2.8
	Tangible book value per common share		7.32		6.88	6.4

Fair Value Measurements and the Fair Value Option for Financial Assets and Financial Liabilities

At September 30, 2013, we had made no elections to use fair value as an alternative measurement for selected financial assets and financial liabilities not previously carried at fair value. For additional information about our financial assets and financial liabilities carried at fair value, refer to “Note 11. Fair Value Disclosures” to the financial statements appearing in Part I, Item 1, of this report.

Securities Available for Sale

Securities available for sale decreased 3.7%, or $94.5 million from December 31, 2012 resulting from a strategic decision, in early 2013, not to purchase securities in most of the first two quarters of 2013 due to the low interest rate environment and reasonable loan demand.  As interest rates have increased, Susquehanna began to increase its volume of purchases during the third quarter.  For additional information about our investment securities portfolio, refer to “Note 3. Investment Securities” and “Note 13. Fair Value Disclosures” to the financial statements appearing in Part I, Item 1, of this report.

Loans and Leases

68

Total loans and leases increased 3.7%, or $481.7 million, from December 31, 2012 to September 30, 2013.  For additional information about our loan portfolio, refer to “Note 4. Loans and Leases”to the financial statements appearing in Part I, Item 1, of this report.

Risk Assets
Table 11
Risk Assets
			September 30		December 31,
			2013		2012		% Change
			(Dollars in thousands)
Non-performing assets:
	Nonaccrual loans and leases:
		Commercial, financial, and agricultural	$	10,048	$	10,464	(4.0)	%
		Real estate - construction		16,497		14,817	11.3
		Real estate secured - residential		27,878		28,440	(2.0)
		Real estate secured - commercial		45,906		42,621	7.7
		Consumer		177		43	311.6
		Leases		1,470		1,382	6.4
	Total nonaccrual loans and leases			101,976		97,767	4.3
	Foreclosed real estate			17,760		26,245	(32.3)
Total non-performing assets			$	119,736	$	124,012	(3.4)
Total non-performing assets as a percentage of period-end
	loans and leases and foreclosed real estate			0.89%		0.96%	(7.3)
Allowance for loan and lease losses as a percentage of
	nonaccrual loans and leases			164%		188%	(12.8)
Loans contractually past due 90 days and still accruing			$	8,655	$	8,209	5.4
Troubled debt restructurings				69,975		67,775	3.2

One of the more significant fair value adjustments in our purchase accounting for the Tower transaction was to loans.  As of February 17, 2012, certain of the loans acquired from Tower had evidence of credit deterioration since origination, and it was probable that we would not collect all contractually required principal and interest payments.  The accounting guidance requires that acquired credit-impaired loans be recorded at fair value and prohibits carryover of the related allowance for loan losses.

The acquired credit-impaired loans were initially recognized at fair value, which incorporates the present value of amounts estimated to be collectible.  Accordingly, such acquired credit-impaired loans are not classified as nonaccrual, even though they may be contractually past due, because we expect to fully collect the fair values of such loans (that is, the new cost basis arising out of our purchase accounting).  Acquired credit-impaired loans are also not included in the disclosure of loans 90 days or more past due and still accruing interest even though certain of them are 90 days or more contractually past due.

As a result of the application of the accounting guidance to Tower’s loan portfolios, certain credit-related ratios of the Company, including, for example, the growth rate in the ratio of non-performing assets since December 31, 2012, may not necessarily be directly comparable with periods prior to the merger or with credit-related ratios of other financial institutions. 

Nonperforming assets decreased from $124.0 million at December 31, 2012, to $119.7 million at September 30, 2013. Consequently, total nonperforming assets as a percentage of period-end loans and leases plus foreclosed real estate decreased from 0.96% at December 31, 2012 to 0.89% at September 30, 2013, and troubled debt restructurings increased $2.2 million, from $67.8 million at December 31, 2012 to $70.0 million at September 30, 2013.

Of the $264.4 million of impaired loans (nonaccrual, non-consumer loan relationships greater than $0.75 million plus accruing restructured loans),  $175.5 million, or 66.4%, had no related reserve(refer to “Note 4. Loans and Leases – Impaired Loans” to the financial statements appearing in Part I, Item 1, of this report.) The determination that no related reserve for collateral-dependent loans was required was based on the net realizable value of the underlying collateral less costs to sell.

69

At September 30, 2013, real estate – construction loans comprised only 5.7% of our total loan and lease portfolio, but accounted for 16.2% of nonaccrual loans and leases and 14.4% of our allowance for loan and lease losses. In addition, for the three-month and nine-month period ended September 30, 2013, this loan type accounted for 38.6%, and 22.1%, respectively, of total net charge-offs.  As a result, we consider real estate - construction loans to be higher-risk loans. Additional information about our real estate – construction loan portfolio is presented in Tables 12, 13, and 14. Categories within these tables are defined as follows:

·Construction loans – loans used to fund vertical construction for residential and non-residential structures;

·Land development loans – loans secured by land for which the approvals for site improvements have been obtained, the site improvements are in progress, or the site improvements have been completed; and

·Raw land – loans secured by land for which there are neither approvals nor site improvements.

Table 12
Construction, Land Development, and Other Land Loans - Portfolio Status
			Balance at				Past Due		Past Due				Other		Net
			September 30,		% of Total		30-89		90 Days and		Non		Internally		Charge-
Category			2013		Construction		Days		Still Accruing		Accrual		Monitored	(1)	Offs	(2)	Reserve	(3)
			(Dollars in thousands)
1-4 Family:
	Construction		$	156,464	20.4	%	0.4	%	0.0	%	2.3	%	12.1	%	0.6	%	3.2	%
	Land development			192,532	25.2		0.3		0.4		0.3		16.8		0.0		3.6
	Raw land			1,290	0.2		0.0		0.0		0.0		0.0		(1.9	)	1.0
				350,286	45.8		0.4		0.2		1.2		14.7		0.3		3.4
All Other:
	Construction:
		Investor		209,737	27.4		0.2		0.0		3.5		6.7		4.1		2.9
		Owner-occupied		46,537	6.1		0.0		0.0		1.2		0.0		0.0		2.5
	Land development:
		Investor		119,274	15.5		0.8		0.0		3.0		26.7		2.9		3.2
		Owner-occupied		14,203	1.9		0.0		0.0		5.9		11.3		1.4		3.5
	Raw land:
		Investor		24,413	3.2		0.0		0.0		0.0		11.7		(0.4	)	1.7
		Owner-occupied		796	0.1		0.0		0.0		0.0		0.0		0.0		0.3
				414,960	54.2		0.3		0.0		3.0		12.1		2.9		2.9
Total			$	765,246	100.0		0.3		0.1		2.2		13.3		1.7		3.1
(1)	Represents loans with initial signs of some financial weakness and potential problem loans that are on our internally monitored loan list, excluding non-accrual and
	past-due loans reflected in the prior three columns.
(2)	Represents the amount of net charge-offs in each category for the last nine months divided by the category loan balance at September 30, 2013 plus the net charge-offs.
(3)	Represents the amount of the allowance for loan and lease losses allocated to this category divided by the category loan balance at September 30, 2013.

70

Table 13
Construction, Land Development, and Other Land Loans - Collateral Locations
			Balance at		Geographical Location by %
Category			September 30, 2013		Maryland		New Jersey		Pennsylvania		Other
			(Dollars in thousands)
1-4 Family:
	Construction		$	156,464	49.7	%	2.9	%	42.0	%	5.4	%
	Land development			192,532	40.9		3.7		39.5		16.0
	Raw land			1,290	0.0		21.6		78.4		0.0
				350,286	44.7		3.4		40.8		11.2
All Other:
	Construction:
		Investor		209,737	54.3		15.1		30.6		0.0
		Owner-occupied		46,537	27.8		3.9		68.4		0.0
	Land development:
		Investor		119,274	29.9		5.2		48.3		16.6
		Owner-occupied		14,203	39.0		0.0		61.0		0.0
	Raw land:
		Investor		24,413	18.7		1.6		76.9		2.8
		Owner-occupied		796	52.1		0.0		47.9		0.0
				414,960	41.7		9.7		43.7		4.9
Total			$	765,246	43.0		6.8		42.4		7.8

71

Table 14
Construction, Land Development, and Other Land Loans - Portfolio Characteristics
						Global Debt
				Balance at		Coverage Ratio		Average Loan to
	Category			September 30, 2013		Less than 1.1 Times (1)		Value (current)
				(Dollars in thousands)
	1-4 Family:
		Construction		$	156,464	8.2	%	86.4	%
		Land development			192,532	12.6		70.5
		Raw land			1,290	0.0		60.2
					350,286	10.8		80.2
	All Other:
		Construction:
			Investor		209,737	19.2		85.7
			Owner-occupied		46,537	10.4		55.9
		Land development:
			Investor		119,274	10.5		82.9
			Owner-occupied		14,203	51.7		48.5
		Raw land:
			Investor		24,413	18.6		68.3
			Owner-occupied		796	46.5		85.7
					414,960	17.1		78.2
				$	765,246	13.7		79.2
(1)	Global debt coverage ratio is calculated by analyzing the combined cash flows of the borrower, its related entities, and the guarantors (if any).  The final global cash flow is divided by the global debt service for the same entities to determine the coverage ratio.

We conduct quarterly portfolio reviews of real estate – construction loan relationships in excess of $0.75 million in order to identify potential problem loans. For those loan relationships under $0.75 million, the evaluation of risk is based upon delinquency. The review of loans in excess of $0.75 million consists of:

·Determining whether the project’s economics are achievable within a time frame such that the available cash flow of this and all of the projects of the borrower/guarantor (whether financed or not financed by Susquehanna) is sufficient to pay the required payments of interest plus principal during a rolling fifteen- month projection.

·Determining, based on a review of external sources, the viability/absorption of the projects and whether they align with the borrower/guarantor’s expectations.

·Reviewing quarterly to assess whether the expectations of the borrower/guarantor and the externally supplied information on the market are aligned to determine if the previous assumptions are still valid or need to be adjusted to meet the expectations that Susquehanna be fully repaid.

During this process, we also review the liquidity of any guarantors (the secondary source for continuance of the project) to determine if their liquidity will support any extension of the project due to slower than expected absorption (units leased or sold).  If the result of any of the determinations set forth above is negative, we consider the loan to be impaired, and it is included in our evaluation of the allowance for loan and lease losses. If a loan is determined to be impaired, the net realizable value of the loan is calculated by using a current (less than one year old) appraisal, and the short fall is charged off. All partially charged-off loans become part of the calculation for the allowance for loan and lease losses.

Although our impairment and charge-off analyses take into consideration the guarantor’s demonstrated ability and willingness to service the debt, we do not carry any impaired loans at values in excess of the current appraisal due to the loan having a guarantor. Our evaluation of guarantors includes examining their financial wherewithal and their reputation and willingness to work with their lenders. Since the beginning of the global economic slowdown in 2007, we have consistently assessed the probability for completion of a project by determining the guarantor’s liquidity and the cash flow generated by the project based upon current absorption. 

72

Charge-offs are taken in the quarter that we determine that the loan is impaired and there is a probable incurred loss. We exercise our rights under the full extent of the law to pursue all assets of the borrower and guarantors.

Guarantors are required to provide us with copies of annual financial statements and tax returns, including all schedules. These financial statements and tax returns are analyzed using variables such as total debt obligation including contingent liabilities (an analysis of those contingent liabilities, the ability to service third-party debt, and whether the cash that is left will support our loan), and a review of financial statements to determine living expenses. These results are part of a fifteen-month rolling projection of the borrower’s and the guarantor’s cash flow.  With respect to a potential problem loan, the rolling fifteen-month cash flow projection requires verification of all cash or liquid investments each quarter.  In addition, we require that these statements are generally current to within one year.

We believe that we are well-equipped to evaluate the guarantors of loans. More than half of our commercial real estate borrowers have been our customers for over ten years and in the market for at least fifteen years. Most of our lenders have been lenders within their specific markets for fifteen or more years, and those whose experience is less than that time period are supervised by people who have the experience. Therefore, we have a strong historical perspective as to how borrowers performed in the last major recession of 1988 to 1993. For those borrowers/guarantors that do not have the history dating back to the last major recession, third-party credit checks are used to determine their history and, when appropriate, how they have performed when real estate projects have not gone as expected.

We continue to aggressively review our portfolio, contact customers to evaluate their financial situation and where necessary, to work with them to find proactive solutions to help limit the number of loans that become delinquent or go into default. We believe that the remainder of 2013 will be challenging, with the volatility of key commodity prices continuing to impact the commercial and industrial, commercial real estate, and consumer credit segments. However, we also believe that we have the proper monitoring systems in place to recognize issues in an appropriate time frame and to minimize the effect on our earnings.

Goodwill

The Tower transaction created $257.4 million of additional goodwill.  For additional information about goodwill, refer to “Note 2. Acquisitions” and “Note 6. Goodwill”to the financial statements appearing in Part I, Item 1, of this report.

Deposits

Total deposits increased 1.1%, or $141.6 million, from December 31, 2012 to September 30, 2013. Within this category, core deposits such as demand, interest-bearing demand, and savings increased 0.7%.

Time deposits less than $0.1 million decreased 7.0%, or $158.6 million, from December 31, 2012 to September 30, 2013. This decrease, in part, reflects the results of our continuing plan to improve our mix of deposits by allowing high-cost, single-service certificates of deposit to run off.  However, we also want to maintain market share and liquidity at appropriate levels, and we will monitor and manage this portfolio to avoid excessive runoff.  Time deposits greater than $0.1 million increased 16.2%, or $240.2 million, from December 31, 2012 to September 30, 2013.  For additional information about deposits, refer to “Note 7. Deposits” to the financial statements appearing in Part I, Item I, of this report.

Shareholders’ Equity

Total shareholders’ equity increased $83.4 million, or 3.2%, during the first nine months of 2013.  The primary components of the change were net income of $132.3 million, offset by dividends paid to shareholders of $29.9 million, or $.16 per share, and a $25.7 million negative adjustment to accumulated other comprehensive income resulting from decreased fair value of available for sale securities, due to market interest rate increases in the latter half of the second quarter.

Capital Adequacy

Capital elements are segmented into two tiers.  Tier I capital represents shareholders’ equity plus junior subordinated debentures, reduced by excludable intangibles. Tier 2 capital represents certain allowable long-term debt, the portion of the allowance for loan and lease losses and the allowance for credit losses on off-balance-sheet credit exposures equal to 1.25% of risk-adjusted assets, and 45% of the unrealized gain on equity securities. The sum of Tier I capital and Tier 2 capital is “total risk-based capital.” Tier I common and tangible common equity include only common equity.

On July 2, 2013, the Board of Governors of the Federal Reserve System approved final rules relating to the implementation of revised capital standards to reflect the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act as well as

73

the Basel III international capital standards. The rules are effective as of January 1, 2014 but have a mandatory compliance date of January 1, 2015 for Susquehanna.

Consistent with the international Basel framework, the rules include a new minimum ratio of common equity tier I capital to risk-weighted assets of 4.5 percent and a common equity tier I capital conservation buffer of 2.5 percent of risk-weighted assets that will apply to all supervised financial institutions. The rules also raise the minimum ratio of tier I capital to risk-weighted assets from 4 percent to 6 percent and include a minimum leverage ratio of 4 percent for all banking organizations. In addition, for the largest, most internationally active banking organizations, which do not include Susquehanna, the final rules include a new minimum supplementary leverage ratio that takes into account off-balance sheet exposures.

The final rules emphasize common equity tier I capital, the most loss-absorbing form of capital, and implements strict eligibility criteria for regulatory capital instruments. The final rules also improve the methodology for calculating risk-weighted assets to enhance risk sensitivity. These changes to the risk-weighted assets calculation will be effective from January 1, 2015 and would likely lead to a minimal increase in our risk-weighted assets, which in some cases could be significant.

The final rules also establish a more conservative standard for including as tier I capital, for bank holding companies such as Susquehanna, instruments such as trust preferred securities. Such bank holding companies must begin to phase-out these instruments as capital on January 1, 2015. Susquehanna will be allowed to include only 25 percent of its $155.0 million in outstanding trust preferred securities as of January 1, 2015, and 0 percent as of January 1, 2016, and thereafter.

Based on a preliminary analysis of the new rules, management believes that it would be fully compliant with the revised standards as of September 30, 2013 if they were effective on that date.

Susquehanna actively reviews its capital strategies in light of current and anticipated business risks, future growth opportunities, industry standards, and compliance with regulatory requirements. The assessment of overall capital adequacy depends on a variety of factors, including asset quality, liquidity, earnings stability, competitive forces, economic conditions, and strength of management. At September 30, 2013, the capital ratios of Susquehanna exceed the “well-capitalized” thresholds under the current capital requirements. The capital ratios as computed under the existing regulatory guidance are as follows:

Table 15
Susquehanna Capital Ratios
				Well-capitalized
			At September 30, 2013	Threshold
		Tier 1 Common Ratio	10.41%	N/A
		Leverage Ratio	9.47%	5.0%
		Tier 1 Capital Ratio	11.52%	6.0%
		Total Risk-based Capital Ratio	12.92%	10.0%
(1)	Includes deferred tax liability of $46.1 million associated with intangibles.

Recently Adopted or Issued Accounting Guidance

For information about the impact that recently adopted or issued accounting guidance will have on our financial statements, refer to “Note 1. Accounting Policies”to the financial statements appearing in Part I,   Item 1, of this report.

74

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

The types of market risk exposures generally faced by banking entities include equity market price risk, liquidity risk, interest rate risk, foreign currency risk, and commodity price risk.

Due to the nature of our operations, foreign currency risk is not significant to us. However, in addition to general banking risks, we have other risks that are related to vehicle leasing and asset securitizations.

There has not been any material changes in the market risks to Susquehanna as reported in Form 10-K for the fiscal year ended December 31, 2012.

Equity Market Price Risk

Equity market price risk is the risk related to market fluctuations of equity prices in the securities markets.  While we do not have significant equity market price risk in our investment portfolio, market price fluctuations may affect fee income generated through our asset management operations. Generally, our fee structure is based on the market value of assets being managed at specific time frames. When market values decline, our fee income also declines.

Liquidity Risk

The maintenance of adequate liquidity – the ability to meet the cash requirements of our customers and other financial commitments – is a fundamental aspect of our asset/liability management strategy.  Our policy of diversifying our funding sources – purchased funds, repurchase agreements, and deposit accounts – allows us to avoid undue concentration in any single financial market and also to avoid heavy funding requirements within short periods of time.  Our bank subsidiary has approximately $2.4 billion available under a collateralized line of credit with the Federal Home Loan Bank of Pittsburgh at September 30, 2013 and December 31, 2012, respectively. In addition, at September 30, 2013 and December 31, 2012, we had unused federal funds lines of $1.1 billion and $1.0 billion, respectively, and aggregate brokered certificates of deposits of $660.2 million and $392.8 million, respectively.

 In addition, we have pledged certain auto leases, certain auto loans, certain commercial finance leases, and certain investment securities to obtain collateralized borrowing availability at the Federal Reserve’s Discount Window.  At September 30, 2013 and December 31, 2012, we had unused collateralized availability of $1.4 billion and $1.1 billion, respectively.

Liquidity, however, is not entirely dependent on increasing our liability balances.  Liquidity is also evaluated by taking into consideration maturing or readily marketable assets. Unrestricted short-term investments totaled $30.7 million and $39.6 million, respectively, at September 30, 2013 and December 31, 2012, and represented additional sources of liquidity.

Management believes these sources of liquidity are sufficient to support our banking operations for the foreseeable future.

Interest Rate Risk

The management of interest rate risk focuses on controlling the risk to net interest income and the associated net interest margin as the result of changing market rates and spreads. Interest rate risk sensitivity is the by-product of the matching or mismatching of the repricing and rate structure of interest-bearing assets and liabilities. Our goal is to manage this exposure within Board approved risk-tolerance limits.

We employ a variety of methods to measure interest rate risk. These methods include basic gap analysis, which points to directional exposure; routine rate shocks simulation; and the evaluation of the change in the economic value of equity. Board directed limits have been adopted for both the rate shock simulations and economic value of equity exposure. By dividing the assets and liabilities into three groups – fixed rate, floating rate, and those which reprice only at our discretion – strategies are developed to control the exposure to interest rate fluctuations.

Static gap analysis reports the difference between interest-rate sensitive assets and liabilities at a specific point in time.  Management uses the static gap methodology to identify our directional interest-rate risk.  Our estimated cumulative one year interest-rate sensitivity gap positions (asset sensitive) as calculated as of September 30, 2013 and December 31, 2012 were 0% and 6% of total assets, respectively.  These estimates include anticipated prepayments on commercial and residential loans, and mortgage-backed securities, in addition to certain repricing assumptions relative to our core deposits.  Traditionally, an institution with more assets repricing than liabilities over a given time frame is considered asset sensitive, and one with more liabilities repricing than assets is considered liability sensitive.  An asset sensitive institution will generally benefit from rising rates, and a liability sensitive institution will generally benefit from declining rates.  Static gap analysis is widely accepted because of its simplicity in identifying interest rate

75

risk exposure; but it does not forecast changes in market spread adjustments, the changing mix of the balance sheet, planned balance sheet management strategies, and the change in prepayment assumptions.

In addition to static gap reports comparing the sensitivity of interest-earning assets and interest-bearing liabilities to changes in interest rates, we also utilize simulation analysis that measures our exposure to interest rate risk.  The financial simulation model calculates the income effect and the economic value of assets, liabilities and equity at current and forecasted interest rates, and at hypothetical higher and lower interest rates at one percent intervals.  The income effect and economic value of defined categories of financial instruments is calculated by the model using estimated cash flows based on embedded options, prepayments, early withdrawals, and weighted average contractual rates and terms.   For economic value calculations, the model also considers discount rates for similar financial instruments.  The economic values of longer-term fixed-rate financial instruments are generally more sensitive to changes in interest rates.  Adjustable-rate and variable-rate financial instruments largely reflect only a change in economic value representing the difference between the contractual and discounted rates until the next contractual interest rate repricing date, unless subject to rate caps and floors.

A portion of our loan portfolio consists of commercial and residential mortgage loans containing embedded options, which permit the borrower to repay the principal balance of the loan prior to maturity (“prepayments”) without penalty.  A loan’s susceptibility for prepayment is dependent upon a number of factors, including the current interest rate versus the contractual interest rate of the loan, the financial ability of the borrower to refinance, the economic benefit and the availability of refinancing at attractive terms in addition to general changes in customers’ needs. Refinancing may also depend upon economic and other factors in specific geographic areas that affect the sales and price levels of residential property.  In a changing interest rate environment, prepayments may increase or decrease depending on the current relative levels and expectations of future short-term and long-term interest rates.  

Changes in market rates and general economic conditions impact our organization’s mortgage-backed security portfolio.  Savings and checking deposits generally may be withdrawn upon the customer's request without prior notice.  A continuing relationship with customers resulting in future deposits and withdrawals is generally predictable, resulting in a dependable source of funds.  Time deposits generally have early withdrawal penalties, while term FHLB borrowings and subordinated notes have prepayment penalties, which discourage customer withdrawal of time deposits.

Our floating-rate loan portfolio is primarily indexed to national interest rate indices.  The portfolio is funded by interest-bearing liabilities which are determined by other indices, primarily deposits and FHLB borrowings.  A changing interest rate environment may result in different levels of changes to the different indices resulting in disproportionate changes in the value of, and the net earnings generated from, such financial instruments. Basis risk is the result of these different changes in the indices, with historical relationships not always being a good indicator.

Our policy, as approved by our Board of Directors, is designed so that we experience no more than a maximum level of decline in net interest income and economic value of equity for various interest rate shock (immediate change) scenarios.  The assumptions used for the interest rate shock analysis are reviewed and updated quarterly.  The following table summarizes the estimated impact that immediate upward changes in interest rates might have on the risk to our net interest income and economic equity.

	Net Interest Income		Economic Value of Equity
	+100bp	+200bp	+100bp	+200bp
September 30, 2013	1.3%	3.8%	-0.5%	-0.9%
December 31, 2012	1.6%	4.5%	0.9%	1.5%
Risk-tolerance	-7.5%	-10.0%	-15.0%	-25.0%

Derivative Financial Instruments and Hedging Activities

Our interest rate risk management strategy involves hedging the repricing characteristics of certain assets and liabilities so as to mitigate adverse effects on our net interest margin and cash flows from changes in interest rates. While we do not participate in speculative derivatives trading, we consider it prudent to use certain derivative instruments to add stability to our interest income and expense, to modify the duration of specific assets and liabilities, and to manage our exposure to interest rate movements.

Additionally, we execute derivative instruments in the form of interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. Those derivatives are immediately hedged by offsetting derivative contracts, such that we minimize our net risk exposure resulting from such transactions. We do not use credit default swaps in our investment or hedging operations.

For additional information about our derivative financial instruments, refer to “Note 13. Derivative

Financial Instruments” and “Note 15. Fair Value Disclosures” to the financial statements appearing in Part I, Item 1, of this report.

76

Vehicle Leasing Residual Value  Risk

In an effort to manage the vehicle residual value risk arising from the auto leasing business of Hann and our bank subsidiary, Hann and the bank have entered into arrangements with Auto Lenders pursuant to which Hann or the bank, as applicable, effectively transferred to Auto Lenders all residual value risk of its respective auto lease portfolio, and all residual value risk on any new leases originated over the term of the applicable agreement. Auto Lenders, which was formed in 1990, is a used-vehicle remarketer with five retail locations in New Jersey and has access to various wholesale facilities throughout the country. Under these arrangements, Auto Lenders agrees to purchase the beneficial interest in all vehicles returned by the obligors at the scheduled expiration of the related leases for a purchase price equal to the stated residual value of such vehicles. Stated residual values of new leases are set in accordance with the standards approved in advance by Auto Lenders. Under a servicing agreement with Auto Lenders, Hann also agrees to make monthly guaranty payments to Auto Lenders based upon a negotiated schedule covering a five-year period.  At the end of each year, the servicing agreement may be renewed by the mutual agreement of the parties for an additional one-year term, beyond the current five-year term, subject to renegotiation of the payments for the additional year.  During the renewal process, we determine the best remarketing and/or residual guarantee alternatives for Hann and our bank subsidiary.

Item 4. Controls and Procedures.

(a)Evaluation of Disclosure Controls and Procedures

Susquehanna’s management, with the participation of Susquehanna’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of Susquehanna’s disclosure controls and procedures as of the end of the period covered by this report.  Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as of the end of the period covered by this report have been designed and are functioning effectively to provide reasonable assurance that the information required to be disclosed by us in reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.  Susquehanna believes that a control system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the control system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

(b)Change in Internal Control Over Financial Reporting

No change in Susquehanna’s internal control over financial reporting occurred during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, Susquehanna’s internal control over financial reporting.

77

PART II--OTHER INFORMATION

Item 1.  Legal Proceedings. 

Susquehanna and its subsidiaries are engaged in lines of business that are heavily regulated and involve a large volume of financial transactions with numerous customers through offices in Pennsylvania, Maryland, New Jersey and West Virginia.  Although we have developed policies and procedures to minimize the impact of legal noncompliance and other disputes, litigation presents an ongoing risk.

Overdraft Litigation 

On July 29, 2011, Susquehanna Bank was named as a defendant in a purported class action lawsuit filed by two New Jersey customers of the bank in the United States District Court of Maryland.  The suit challenges the manner in which checking account overdraft fees were charged and the policies related to the posting order of debit card and other checking account transactions.  The suit makes claims under New Jersey’s consumer fraud act and under the common law for breach of contract, breach of the covenant of good faith and fair dealing, unconscionability, conversion and unjust enrichment. The case was transferred for pretrial proceedings to pending multi-district litigation in the U.S. District Court for the Southern District of Florida. 

To avoid the costs, risks and uncertainties inherent in litigation and without admitting any of the allegations in the complaint, Susquehanna in good faith participated in mediation with plaintiffs’ counsel and as a result of negotiations following from the mediation, on December 20, 2012, Susquehanna and counsel for plaintiffs entered into a Summary Agreement agreeing to settle the suit for $3,680,000, subject to preliminary and final approval of the settlement and dismissal of the action with prejudice by the Court. 

Management, after consultation with legal counsel, currently does not anticipate that the aggregate settlement amount arising out of this proceeding will have a material adverse effect on our results of operation, financial position, or cash flows.

Other Legal Proceedings

From time to time, Susquehanna receives subpoenas and other requests for information from various federal and state governmental and regulatory authorities in connection with certain industry-wide, company-specific or other investigations or proceedings.  Susquehanna’s policy is to be fully cooperative with such inquiries.  Susquehanna and certain of its subsidiaries have been named as defendants in various legal actions arising out of the normal course of business, including claims against entities to which Susquehanna is a successor as a result of business combinations.  In the opinion of management, the ultimate resolution of these lawsuits should not have a material adverse effect on Susquehanna’s business, consolidated financial position or results of operations.  It is possible, however, that future developments could result in an unfavorable ultimate outcome for or resolution of any one or more of the lawsuits in which Susquehanna or its subsidiaries are defendants, which may be material to Susquehanna’s results of operations for a particular quarterly reporting period.  Litigation is inherently uncertain, and management cannot make assurances that Susquehanna will prevail in any of these actions, nor can management reasonably estimate the amount of damages that Susquehanna might incur.

Item 1A. Risk Factors.

There have been no material changes to the risk factors disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Item 3. Defaults Upon Senior Securities.

None.

Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information.

None.

78

Item 6. Exhibits.†
The Exhibits filed as part of this report are as follows:
3.1	Amended and Restated Articles of Incorporation, dated May 6, 2011, incorporated by reference to Exhibit 3.1 to Susquehanna’s Quarterly Report on Form 10-Q, filed August 8, 2011.
3.2	Amended and Restated By-Laws, dated February 24, 2011, incorporated by reference to Exhibit 3.1 of Susquehanna’s Current Report on Form 8-K, filed March 2, 2011.
31.1	Rule 13a-14(a)/15d-14(a) Certification by Chief Executive Officer is filed herewith as Exhibit 31.1.
31.2	Rule 13a-14(a)/15d-14(a) Certification by Chief Financial Officer is filed herewith as Exhibit 31.2.
32	Section 1350 Certifications are filed herewith as Exhibit 32.
101.INS	XBRL Instance Document
101.SCH	XBRL Taxonomy Extension Schema Document
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document
101.LAB	XBRL Taxonomy Extension Label Linkbase Document
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document
101.DEF	XBRL Taxonomy Extension Definitions Linkbase Document
†	Upon request by the SEC, the registrant agrees to furnish to the SEC a copy of any instrument with respect to unregistered long-term debt of the registrant in accordance with Item 601(b)(4)(iii)(A) of Regulation S-K promulgated under the Exchange Act.

79

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

                                                                                            SUSQUEHANNA BANCSHARES, INC.           

November 5, 2013                                                          /s/ William J. Reuter                                                                                                                                                                                                                      William J. Reuter

                                                                                            Chairman and Chief Executive Officer

November 5, 2013                                                          /s/ Drew K. Hostetter                                                              

                                                                                          Drew K. Hostetter

                                                                                    Executive Vice President and Chief

                                                                                            Financial Officer

80

EXHIBIT INDEX
3.1	Amended and Restated Articles of Incorporation, dated May 6, 2011, incorporated by reference to Exhibit 3.1 to Susquehanna’s Quarterly Report on Form 10-Q, filed August 8, 2011.
3.2	Amended and Restated By-Laws, dated February 24, 2011, incorporated by reference to Exhibit 3.1 of Susquehanna’s Current Report on Form 8-K, filed March 2, 2011.
31.1	Rule 13a-14(a)/15d-14(a) Certification by Chief Executive Officer is filed herewith as Exhibit 31.1.
31.2	Rule 13a-14(a)/15d-14(a) Certification by Chief Financial Officer is filed herewith as Exhibit 31.2.
32	Section 1350 Certifications are filed herewith as Exhibit 32.
101.INS	XBRL Instance Document
101.SCH	XBRL Taxonomy Extension Schema Document
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document
101.LAB	XBRL Taxonomy Extension Label Linkbase Document
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document
101.DEF	XBRL Taxonomy Extension Definitions Linkbase Document

81