United States

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.   20549

FORM 10-Q

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

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2012

OR

o     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 000 - 19300

NORTHERN STATES FINANCIAL CORPORATION

(Exact name of Registrant as specified in its charter)

Delaware	36-3449727
(State of Incorporation)	(I.R.S. Employer Identification No.)

1601 North Lewis Avenue

Waukegan, Illinois  60085

(847) 244-6000

(Address, including zip code, and telephone number, including area code, of principal executive office)

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

Indicate by check mark whether the registrant 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: o

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

Large Accelerated Filer o	Accelerated Filer o	Non-accelerated Filer o	Smaller reporting company x
		(Do not check if a 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: o NO: x

4,277,755 shares of common stock were outstanding at April 30, 2012

NORTHERN STATES FINANCIAL CORPORATION AND SUBSIDIARY

FORM 10-Q

For the Quarter Ended March 31, 2012

INDEX

PART I.   FINANCIAL INFORMATION
		Page Number
Item 1.	Financial Statements
	Report of Independent Registered Public Accounting Firm	2
	Condensed Consolidated Financial Statements and Notes	3
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	33
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	46
Item 4.	Controls and Procedures	47
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings	48
Item 1A.	Risk Factors	48
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	48
Item 3.	Defaults Upon Senior Securities	48
Item 4.	Mine Safety Disclosures	48
Item 5.	Other Information	48
Item 6.	Exhibits	49
Signatures		50
EXHIBIT INDEX		51

1

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders

Northern States Financial Corporation

Waukegan, Illinois

We have reviewed the accompanying interim condensed consolidated balance sheet of NORTHERN STATES FINANCIAL CORPORATION as of March 31, 2012, the condensed consolidated statements of operations and comprehensive income (loss) for the three month periods ended March 31, 2012 and 2011 and the condensed statements of cash flows and stockholders equity for the three month periods ended March 31, 2012 and 2011.  These interim financial statements are the responsibility of the company's management.

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

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

/s/  Plante & Moran, PLLC

Chicago, Illinois

May 1, 2012

2

NORTHERN STATES FINANCIAL CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

March 31, 2012 and December 31, 2011

(In thousands of dollars) (Unaudited)

	March 31,			December 31,
	2012			2011
Assets
Cash and due from banks	$	7,442		$	5,313
Interest bearing deposits in financial institutions -maturities less than 90 days		29,925			32,520
Total cash and cash equivalents		37,367			37,833
Securities available for sale		85,232			87,140
Loans and leases, net of deferred fees		316,833			322,713
Less: Allowance for loan and lease losses		(19,026	)		(18,984	)
Loans and leases, net		297,807			303,729
Federal Home Loan Bank stock		1,434			1,801
Office buildings and equipment, net		8,926			9,069
Other real estate owned		17,859			19,342
Accrued interest receivable		1,481			1,401
Other assets		2,846			2,675
Total assets	$	452,952		$	462,990
Liabilities and Stockholders' Equity
Liabilities
Deposits
Demand - noninterest bearing	$	70,695		$	67,955
Interest bearing		321,142			329,676
Total deposits		391,837			397,631
Securities sold under repurchase agreements		16,639			19,455
Subordinated debentures		10,310			10,310
Advances from borrowers for taxes and insurance		1,960			1,222
Accrued interest payable and other liabilities		6,634			5,833
Total liabilities		427,380			434,451
Stockholders' Equity
Common stock (Par value $0.40 per share, authorized 6,500,000 shares, issued 4,472,255 at March 31, 2012 and December 31, 2011.  Shares outstanding of 4,277,755 at March 31, 2012 and December 31, 2011)		1,789			1,789
Preferred stock (Par value $0.40 per share, authorized 1,000,000 shares, issued 17,211 shares with liquidation amounts of $1,000.00 per share at March 31, 2012 and December 31, 2011)		16,939			16,904
Warrants (584,084 issued and outstanding at March 31, 2012and December 31, 2011)		681			681
Additional paid-in capital		7,084			7,054
Retained earnings		2,371			5,489
Treasury stock, at cost (194,500 shares at March 31, 2012 and December 31, 2011)		(4,512	)		(4,512	)
Accumulated other comprehensive income (loss), net		1,220			1,134
Total stockholders' equity		25,572			28,539
Total liabilities and stockholders' equity	$	452,952		$	462,990

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

3

NORTHERN STATES FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Three months ended March 31, 2012 and 2011

(In thousands of dollars, except per share data) (Unaudited)

	Three months ended
	March 31,			March 31,
	2012			2011
Interest income
Loans (including fee income)	$	4,098		$	4,835
Securities
Taxable		506			562
Exempt from federal income tax		30			36
Federal funds sold and other		14			16
Total interest income		4,648			5,449
Interest expense
Time deposits		204			623
Other deposits		87			91
Repurchase agreements and federal funds purchased		8			30
Subordinated debentures		65			57
Total interest expense		364			801
Net interest income		4,284			4,648
Provision for loan and lease losses		1,400			1,200
Net interest income after provision for loan and lease losses		2,884			3,448
Noninterest income
Service fees on deposits		383			413
Trust income		149			194
Net (loss) gain on sale of other real estate owned		(216	)		67
Other than temporary impairment of securities		0			(143	)
Noncredit portion of other than temporary impairment of securities		0			(20	)
Other operating income		335			322
Total noninterest income		651			833
Noninterest expense
Salaries and employee benefits		1,761			1,793
Occupancy and equipment, net		600			673
Data processing		572			507
Legal		180			205
FDIC insurance		256			381
Audit and other professional		290			286
Printing and supplies expense		68			80
Write-down of other real estate owned		1,972			673
Other real estate owned expense		126			233
Loan and collection		99			108
Other operating expenses		451			444
Total noninterest expense		6,375			5,383
Loss before income taxes		(2,840	)		(1,102	)
Income tax expense		0			0
Net loss		(2,840	)		(1,102	)
Dividends to preferred stockholders		243			230
Accretion of discount on preferred stock		35			34
Net loss available to common stockholders	$	(3,118	)	$	(1,366	)
Basic loss per share	$	(0.73	)	$	(0.32	)
Diluted loss per share	$	(0.73	)	$	(0.32	)

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

4

NORTHERN STATES FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

Three months ended March 31, 2012 and 2011

(In thousands of dollars) (Unaudited)

	Three months ended
	March 31,			March 31,
	2012			2011
Net loss	$	(2,840	)	$	(1,102	)
Other comprehensive income:
Unrealized gains on securities available for sale, net of tax		86			331
Comprehensive loss	$	(2,754	)	$	(771	)

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

5

NORTHERN STATES FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

Three months ended March 31, 2012 and 2011

(In thousands of dollars) (Unaudited)

	Common Stock		Preferred Stock		Warrants		Additional Paid-In Capital			Retained Earnings			Treasury Stock, at Cost			Accumulated Other Comprehensive Income (Loss), Net			Total Stockholders' Equity
Balance, December 31, 2010	$	1,789	$	16,768	$	681	$	11,584		$	13,250		$	(9,280	)	$	(1,507	)	$	33,285
Net loss											(1,102	)								(1,102	)
Accrued dividend on preferred stock											(230	)								(230	)
Accretion of preferred stock discount issued				34							(34	)								0
Restricted stock awards from treasury stock								(4,814	)					4,814						0
Restricted stock awards expense								152												152
Unrealized net gain on securities available for sale																	331			331
Balance, March 31, 2011	$	1,789	$	16,802	$	681	$	6,922		$	11,884		$	(4,466	)	$	(1,176	)	$	32,436
Balance, December 31, 2011	$	1,789	$	16,904	$	681	$	7,054		$	5,489		$	(4,512	)	$	1,134		$	28,539
Net loss											(2,840	)								(2,840	)
Accrued dividend on preferred stock											(243	)								(243	)
Accretion of preferred stock discount issued				35							(35	)								0
Restricted stock awards expense								30												30
Unrealized net gain on securities available for sale																	86			86
Balance, March 31, 2012	$	1,789	$	16,939	$	681	$	7,084		$	2,371		$	(4,512	)	$	1,220		$	25,572

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

6

NORTHERN STATES FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Three months ended March 31, 2012 and 2011

(In thousands of dollars) (Unaudited)

	Three months ended
	2012			2011
Cash flows from operating activities
Net loss	$	(2,840	)	$	(1,102	)
Adjustments to reconcile net loss to net cash from operating activities:
Depreciation		173			171
Net impairment loss on securities		0			163
Provision for loan and lease losses		1,400			1,200
Write-down of other real estate owned		1,972			673
Net loss (gain) on sale of other real estate owned		216			(67	)
Restricted stock awards expense		30			152
Net change in accrued interest receivable and other assets		407			781
Net change in accrued interest payable and other liabilities		(164	)		(172	)
Net cash provided from operating activities		1,194			1,799
Cash flows from investing activities
Proceeds from maturities, calls and principal reductions of securities available for sale		2,058			1,739
Redemptions of Federal Home Loan Bank stock		367			0
Changes in loans made to customers		3,069			10,622
Property and equipment expenditures		(30	)		(24	)
Proceeds from sale of other real estate owned		748			1,544
Net cash provided from investing activities		6,212			13,881
Cash flows from financing activities
Net increase (decrease) in:
Deposits		(5,794	)		5,429
Securities sold under repurchase agreements and other short-term borrowings		(2,816	)		(7,371	)
Advances from borrowers for taxes and insurance		738			790
Net cash used in financing activities		(7,872	)		(1,152	)
Net change in cash and cash equivalents		(466	)		14,528
Cash and cash equivalents at beginning of period		37,833			30,357
Cash and cash equivalents at end of period	$	37,367		$	44,885
Supplemental disclosures
Cash paid for interest	$	408		$	930
Noncash transfer of loans to other real estate owned		1,453			61
Noncash accrual of preferred dividends		243			230

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

7

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

Note 1 - Basis of Presentation

The accompanying interim condensed consolidated financial statements are prepared without audit and reflect all adjustments which are of a normal and recurring nature and, in the opinion of management, are necessary to present interim financial statements of Northern States Financial Corporation (the "Company") in accordance with accounting principles generally accepted in the United States of America. The interim financial statements do not purport to contain all the necessary financial disclosures covered by accounting principles generally accepted in the United States of America that might otherwise be necessary for complete financial statements.

To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information.  These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ.  Estimates and assumptions used for the allowance for loan and lease losses, valuation of other real estate owned, valuation of other than temporarily impaired securities, valuation of deferred tax assets and status of contingencies are particularly subject to change.

 The interim condensed consolidated financial statements should be read in conjunction with the audited financial statements and accompanying notes (or "notes thereto") of the Company for the years ended December 31, 2011 and 2010 included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 as filed with the Securities and Exchange Commission.  The results of operations for the three month period ended March 31, 2012 included herein are not necessarily indicative of the results to be expected for the full year 2012.

Net loss available to common stockholders was utilized to calculate loss per share for all periods presented.  During the periods presented, the Company had preferred stock and common stock equivalents from warrants related to funds received from the U.S Department of the Treasury (the “Treasury Department”) through its Capital Purchase Program.  However, common stock equivalents from warrants during the periods presented were antidilutive and, therefore, not considered in computing diluted loss per share.

8

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

(Dollars in thousands, except per share data)	Three Months Ended
	March 31,
	2012			2011
Basic earnings per share:
Net loss	$	(2,840	)	$	(1,102	)
Dividends accrued to preferred stockholders		243			230
Accretion of discount on preferred stock		35			34
Net loss available to common stockholders	$	(3,118	)	$	(1,366	)
Weighted average common shares outstanding		4,277,755			4,270,553
Basic loss per share	$	(0.73	)	$	(0.32	)
Diluted earnings per share:
Net loss	$	(2,840	)	$	(1,102	)
Dividends accrued to preferred stockholders		243			230
Accretion of discount on preferred stock		35			34
Net loss available to common stockholders	$	(3,118	)	$	(1,366	)
Weighted average common shares outstanding		4,277,755			4,270,553
Add: Dilutive effect of common stock equivalents		0			0
Weighted average common and dilutive common shares outstanding..		4,277,755			4,270,553
Diluted loss per share	$	(0.73	)	$	(0.32	)

Note 2 – Preferred Stock

On February 20, 2009, pursuant to the Treasury Department’s TARP Capital Purchase Program, the Company issued to the Treasury Department, in exchange for total proceeds of $17,211,000, (i) 17,211 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”), par value $.40 per share and a liquidation amount equal to $1,000 per share, and (ii) a ten-year warrant (the “Warrant”) to purchase up to 584,084 shares of the Company’s common stock, at an exercise price of $4.42 per share.  The $17,211,000 proceeds were allocated to the Series A Preferred Stock and the Warrant based on the relative fair value of the instruments.  The fair value of the preferred stock was estimated using an approximate 12% discount rate and a five-year expected life.  A fair value of $681,000 was estimated for the warrants using a Black-Sholes valuation.  The assumptions used in the Black-Sholes valuation were as follows: $4.42 strike price based on the contract, approximately 53% for the calculated volatility, 3.1% for the weighted average dividends, five years for the expected term and 2% for the risk free rate.

The difference between the initial carrying value of $16,530,000 that was allocated to the Series A Preferred Stock and its redemption value of $17,211,000 will be charged to retained earnings (with a corresponding increase to the carrying value of the Series A Preferred Stock) over the first five years as an adjustment to the dividend yield using the effective yield method.  The Series A Preferred Stock is generally non-voting and qualifies as Tier 1 capital.

9

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

In the event of a liquidation or dissolution of the Company, the Series A Preferred Stock then outstanding takes precedence over the Company’s common stock for the payment of dividends and distribution of assets.

Dividends are payable quarterly on the Series A Preferred Stock at an annual dividend rate of 5% per year for the first five years, and 9% per year thereafter.  The effective yield of the Series A Preferred Stock is approximately 5.94%.  In November 2009, the Company notified the Treasury Department of its intent to suspend its dividend payments on its Series A Preferred Stock.  The suspension of the dividend has continued through March 31, 2012.  At March 31, 2012, the accumulated dividends payable to the Treasury Department totaled $2.4 million which includes compounding on unpaid dividends at 5.00%.  The suspension of dividend payments is permissible under the terms of the TARP Capital Purchase Program, but the dividend is a cumulative dividend and failure to pay dividends for six dividend periods triggers board of director appointment rights for the holder of the Series A Preferred Stock.  At March 31, 2012, the Company had suspended ten dividend payments and expects that the Treasury Department will appoint two directors in 2012.  In January 2011, the Company agreed to allow a Treasury Department representative to attend its Board of Directors meetings as an observer.

For as long as any shares of Series A Preferred Stock are outstanding, no dividends may be declared or paid on the Company’s common stock unless all accrued and unpaid dividends for all past dividend periods on the Series A Preferred Stock are fully paid. Pursuant to the Capital Purchase Program, the Treasury Department’s consent is required for any increase in dividends on the Company’s common stock above the amount of $0.40 per share, the last semi-annual common stock dividend declared by the Company prior to October 14, 2008, unless the Series A Preferred Stock is redeemed in whole or until the Treasury Department has transferred all of the Series A Preferred Stock it owns to third parties.

The Company may not repurchase any of its common stock without the prior consent of the Treasury Department for as long as the shares of Series A Preferred Stock are outstanding to the Treasury Department or until the Treasury Department transfers all of the Series A Preferred Stock it owns to third parties.

Note 3 – Common Stock

Information related to common stock at the dates indicated was as follows:

	March 31, 2012		December 31, 2011
Par value per share	$	0.40	$	0.40
Authorized shares		6,500,000		6,500,000
Issued shares		4,472,255		4,472,255
Treasury shares		194,500		194,500
Outstanding shares		4,277,755		4,277,755

Pursuant to the Capital Purchase Program, the Company issued to the Treasury Department a Warrant to purchase up to 584,084 shares of the Company’s common stock at an exercise price of $4.42 per share.  Based upon its fair value relative to the Series A Preferred Stock discussed in Note 2 above, the Warrant was recorded at a value of $681,000 and is accounted for as equity.  The Warrant is exercisable, in whole or in part, at any time and from time to time until the tenth anniversary of the issue date.

10

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

The 2009 Restricted Stock Plan (the "Plan") authorizes the issuance of 400,000 shares of the Company's common stock to be issued in whole or in part from treasury shares or authorized and unissued shares not reserved for any other purpose. Awards under the Plan may be made to directors and employees of both the Company and its subsidiaries an d may consist of restricted stock with associated voting rights and the right to receive dividends.  Awards may also be issued as stock units not having voting rights or the right to receive dividends until the terms of the award are satisfied and the shares of the Company's stock are actually issued; however, dividends may be credited to a restricted stock award.  The terms and conditions of each award is set forth and described in an award agreement between the Company and the participant.

In January 2011, 207,500 shares of restricted stock were issued pursuant to the 2009 Restricted Stock Plan from the Company’s treasury stock.  During the second and third quarters of 2011, employees, who left the Company, forfeited 2,000 shares of restricted stock, which were returned to treasury stock lowering the total shares issued pursuant to the Plan to 205,500 shares.  Of the 80,000 shares issued to directors, 70,000 shares vested during the first quarter of 2011, while the remaining 10,000 shares fully vest in January 2013.  A total of 125,500 restricted stock shares granted to employees of the Company will fully vest in January 2013.  The expense attributable to these restricted stock awards recognized during the three months ended March 31, 2012 and 2011 totaled $30,000 and $152,000, respectively.

Note 4 – Securities

At March 31, 2012 and December 31, 2011, the Company had the following securities in its investment portfolio:

			Gross Unrealized
March 31, 2012  ($000's)	Fair Value		Gain		Loss
States and political subdivisions	$	2,984	$	102	$	(8	)
Mortgage-backed securities		77,995		1,698		0
Equity securities		4,253		150		0
Total securities available for sale	$	85,232	$	1,950	$	(8	)

11

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

			Gross Unrealized
December 31, 2011  ($000's)	Fair Value		Gains		Losses
States and political subdivisions	$	3,117	$	112	$	(10	)
Mortgage-backed securities		79,762		1,533		0
Equity securities		4,261		157		0
Total securities available for sale	$	87,140	$	1,802	$	(10	)

At March 31, 2012, the Company had pledged securities of $51.2 million as compared to $57.0 million at December 31, 2011.  Securities are pledged to secure public deposits, repurchase agreements and for other purposes as required or permitted by law.

Contractual maturities of securities available for sale at March 31, 2012 are set forth below. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately:

	Fair
March 31, 2012  ($000's)	Value
Due in one year or less	$	124
Due after one year through five years		544
Due after five years through ten years		1,167
Due after ten years		1,149
		2,984
Mortgage-backed securities		77,995
Equity securities		4,253
Total securities available for sale	$	85,232

During the quarter ended March 31, 2012, the Company did not recognize any other than temporary impairment loss as compared with $163,000 recognized during the quarter ended March 31, 2011.  For the quarter ended March 31, 2011, the Company recognized $134,000 of impairment losses on Collateralized Debt Obligations ("CDOs") classified as other bonds based on cash flow analyses pursuant to guidelines on recognition of impairment losses and wrote off the remaining carrying value of these securities.  The Company also recognized $29,000 of other than temporary impairment loss on its FNMA and FHLMC preferred stocks, writing off the remaining carrying value of these securities during the first quarter of 2011.

12

At March 31, 2012 and December 31, 2011, the Company had six and seven individual securities, respectively in an unrealized loss position.  The securities with unrealized losses at March 31, 2012 and December 31, 2011, aggregated by investment category and length of time that individual securities have been in a continuous loss position, were as follows:

	Less than 12 Months					12 Months or More				Total
	Fair		Unrealized			Fair		Unrealized		Fair		Unrealized
March 31, 2012  ($000's)	Value		Losses			Value		Losses		Value		Losses
States and political subdivisions	$	817	$	(8	)	$	0	$	0	$	817	$	(8	)
Total temporarily impaired	$	817	$	(8	)	$	0	$	0	$	817	$	(8	)

	Less than 12 Months					12 Months or More				Total
	Fair		Unrealized			Fair		Unrealized		Fair		Unrealized
December 31, 2011  ($000's)	Value		Losses			Value		Losses		Value		Losses
States and political subdivisions	$	941	$	(10	)	$	0	$	0	$	941	$	(10	)
Total temporarily impaired	$	941	$	(10	)	$	0	$	0	$	941	$	(10	)

Management has the intent and ability to hold these securities in an unrealized loss position for the foreseeable future. Management believes that it is unlikely that the Company will be required to sell the securities while they are in an unrealized loss position.

Note 5 – Subordinated Debentures

During September 2005, the Company issued $10.3 million of subordinated debentures to Northern States Statutory Trust I, a wholly-owned grantor trust, which in turn issued $10.3 million of trust preferred securities.  The Company is required to hold $310,000 of the trust preferred securities as Common Securities while the remaining $10 million were issued as Capital Securities.  The subordinated debentures mature in September 2035.   The subordinated debentures currently and until maturity bear an interest rate of the 3-month London Interbank Offered Rate (“LIBOR”) plus 1.80% adjusted quarterly.  The rate on the subordinated debentures was 2.27365% at March 31, 2012, which is the effective rate from March 15, 2012 through June 14, 2012.  For the three months ended March 31, 2012 and 2011, interest expense on the subordinated debentures was $65,000 and $57,000, respectively.

The Company has guaranteed the payment of distributions and payments upon liquidation or redemption of the trust preferred securities, in each case to the extent of funds held by the Trust. The Company and the Trust believe that, taken together, the obligations of the Company under the guarantee, the subordinated debentures, and other related agreements provide, in the aggregate, a full, irrevocable and unconditional guarantee, on a subordinated basis, of all of the obligations of the Trust under the trust preferred securities. Subject to certain limitations, the Company has the right to defer the payment of interest on the junior subordinated debentures at any time, or from time to time, for a period not to exceed 20 consecutive quarters.  In November 2009, the Company notified the trustee that holds the Company’s junior subordinated debentures relating to its outstanding trust preferred securities that the Company would be deferring its regularly scheduled quarterly interest payments.  The Company has continued to defer its quarterly interest payments through March 31, 2012.  As of March 31, 2012, the Company had deferred ten quarterly payments and accrued interest payable on the subordinated debentures totaled $808,000.  During the deferral period, the Company may not pay any dividends on its common or preferred stock. The trust preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the subordinated debentures at maturity or their earlier redemption. The subordinated debentures were callable at par beginning on September 15, 2010 at the discretion of the Company if certain conditions are met, and in any event, only after the Company obtains Federal Reserve approval, if required under applicable guidelines or regulations.  Subject to certain exceptions, the Company may not without the consent of the Treasury Department engage in repurchases of the Company’s common stock or trust preferred securities until all shares of Series A Preferred Stock issued to the Treasury Department have been redeemed or transferred by the Treasury Department.

13

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

Regulations allow bank holding companies and banks to include subordinated debentures, subject to some limitations, as a component of capital for the purpose of meeting certain regulatory requirements.

Note 6 – Allowance for Loan and Lease Losses and Credit Disclosures

The allowance for loan and lease losses (“ALLL”) is a valuation allowance for probable incurred credit losses, increased by the provision for loan and lease losses and decreased by charge-offs net of recoveries. The ALLL represents one of the most significant estimates in the Bank’s financial condition. Accordingly, the Bank endeavors to provide a comprehensive and systematic approach for determining management’s current judgment about the credit quality of the loan portfolio.

At the end of each quarter, or more frequently if warranted, the Bank analyzes its loan portfolio to determine the level of ALLL needed to be maintained.  Management believes this analysis results in a prudent, conservative ALLL that falls within an acceptable range of estimated credit losses. The ALLL covers estimated credit losses on individually evaluated loans that are determined to be impaired as well as estimated credit losses inherent in the remainder of the loan portfolio.

Senior management and other lenders review all Watch and Substandard credits to determine if a loan is impaired. A loan is considered impaired if it is probable that full principal and interest will not be collected within the contractual terms of the original note. For loans that are individually evaluated and determined to be impaired, the Bank calculates the amount of impairment based on whether repayment of the loan is dependent on operating cash flow or on the underlying collateral. The decision of which method to use is determined by looking at a number of factors, including the size of the loan and other available information. If the loan is to be repaid primarily from the operating cash flow from the borrower, the impairment analysis calculates the present value of the expected future cash flows discounted at the loan’s effective interest rate and compares the result to the recorded investment. Collateral-dependent loans are measured against the fair value of the collateral less the costs to sell.

As of December 31, 2011, management further refined its methodology for calculating the amount in the ALLL by segregating a component of loans considered to be “high risk” but lack sufficient weakness to be considered impaired. These loans are assigned a specific percentage allocation, adjusted by environmental and qualitative factors management believes may affect the repayment of these loans.  The impact to the ALLL for the creation of this additional pool of loans was not significant at December 31, 2011 and March 31, 2012.

The remaining unimpaired loan portfolio is segmented into groups based on loan types having similar risk characteristics. Estimated loan losses for these groups are determined using historical loss experience and adjusted for other environmental and qualitative factors the Bank deems significant that would likely cause estimated credit losses to differ from the group’s historical loss experience.

14

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

Allocations of the ALLL may be made for specific loans and leases, but the entire allowance is available for any loan or lease that, in management’s judgment, should be charged-off. Loan and lease losses are charged against the allowance when management believes the uncollectibility of a loan or lease balance is confirmed.

It is the Company’s policy to administer and pursue charged-off borrowers with the same diligence as other loans.  Charging off an exposure is an accounting entry and does not affect the borrower’s obligation to repay the indebtedness.  Administration of charged-off exposure is governed by maximization of recoveries, and borrowers will be pursued until, in the opinion of management, future costs of collection exceed probable future recoveries.

Activity in the allowance for loan and lease losses for the three months ended March 31, 2012 and 2011 is set forth below:

For the Three Months Ended	Beginning										Ending
March 31, 2012  ($000's)	Balance					Recoveries		Provision			Balance
	Allowance					to Loans		Charges to			Allowance
	for Loan		Loans			Previously		Operating			for Loan
	Losses		Charged Off			Charged Off		Expense			Losses
Commercial	$	792	$	(6	)	$	0	$	326		$	1,112
Real estate-construction		3,149		(1,228	)		0		(68	)		1,853
Real estate-mortgage 1-4 family		865		(76	)		1		63			853
Real estate-mortgage 5+ family		1,646		0			0		68			1,714
Real estate-mortgage commercial		12,018		0			0		689			12,707
Home equity		500		(48	)		0		321			773
Leases		0		0			0		0			0
Installment		14		(1	)		0		1			14
Total	$	18,984	$	(1,359	)	$	1	$	1,400		$	19,026

For the Three Months Ended	Beginning										Ending
March 31, 2011  ($000's)	Balance					Recoveries		Provision			Balance
	Allowance					to Loans		Charges to			Allowance
	for Loan		Loans			Previously		Operating			for Loan
	Losses		Charged Off			Charged Off		Expense			Losses
Commercial	$	1,013	$	0		$	4	$	182		$	1,199
Real estate-construction		2,842		(1	)		0		(567	)		2,274
Real estate-mortgage 1-4 family		988		(254	)		0		(18	)		716
Real estate-mortgage 5+ family		1,025		0			0		884			1,909
Real estate-mortgage commercial		11,977		(750	)		0		721			11,948
Home equity		468		0			0		(3	)		465
Leases		0		0			0		0			0
Installment		23		(4	)		1		1			21
Total	$	18,336	$	(1,009	)	$	5	$	1,200		$	18,532

15

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

Nonaccrual Loans:   Accrual of uncollectible income on problem loans inflates income and, if recognized in an untimely fashion, can have a dramatic negative impact on earnings.  Any loan meeting one of the following criteria is placed in a nonaccrual status and all related interest earned but not collected is reversed:

A. The loan is maintained on a cash basis because of deterioration in the financial condition of the borrower.

B. The borrower is in bankruptcy and the exposure is not fully secured and in the process of collection.

C. Full payment of principal or interest is not expected.

D. The loan has been in default for a period of ninety (90) days or more unless the asset is both well secured and in the process of collection.

Loans meeting any of the criteria above may be exempted from this policy if unanimously agreed upon and duly documented by the Directors Loan Committee. In general, all accrued and earned but not collected interest on an exposure placed on nonaccrual status is charged-off to income. A loan may be returned to accrual status when at least six (6) consecutive months of timely payments have been received and there is evidence to support the payments will continue.

The Company is attempting to work with nonaccrual borrowers to resolve the issues, but in many cases the Company may have to foreclose on the properties securing these loans if the loans are secured by real estate.

Troubled Debt Restructuring:  Restructuring of loans is undertaken to improve the likelihood that the loan will be repaid in full under the modified terms in accordance with a reasonable repayment schedule. All restructured loans are evaluated to determine whether the loans should be reported as a TDR. A loan is a TDR when the Company, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower by modifying or renewing a loan that the Company would not otherwise consider. To make this determination the Bank must determine whether (a) the borrower is experiencing financial difficulties and (b) the Company granted the borrower a concession. This determination requires consideration of all of the facts and circumstances surrounding the modification. An overall general decline in the economy or some deterioration in a borrower’s financial condition does not automatically mean the borrower is experiencing financial difficulties.

Some of the factors reviewed to determine whether the borrower is experiencing financial difficulties are: 1) is the borrower currently in default on any of its debts; 2) has the borrower declared or in the process of declaring bankruptcy; or 3) absent the current modification, would the borrower more than likely default. Factors to consider in determining whether the Company has granted a concession include: lowering the interest rate, extending the maturity date, forgiving debt, reducing accrued interest or changing the payment to interest only for an extended period of time.

16

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

For regulatory purposes, a restructured loan classified as a TDR need not continue to be reported as such in calendar years after the year in which the restructuring took place if the loan yields a market rate and is in compliance with the loan’s modified terms. In determining whether the rate is a market rate the Company considers the riskiness of the transaction, the structure of the loan, the borrower’s financial condition, financial support of the guarantor and protection provided by the collateral. The Company also considers rates given to other borrowers for similar loans as well as what competitors are offering. To be in compliance with the modified loan terms the borrower should demonstrate the ability to repay under the modified terms for a period of at least six months and provide evidence to support that payments will continue.

Loan Rating System:  Senior management and the Bank’s lenders use a loan rating system to determine the credit risks of the Bank’s loan and leases with the following loan ratings:

Pass:  A Pass loan has no apparent weaknesses.

Watch:  A Watch loan has potential weaknesses that deserve management’s close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date.  Loan collection is not in jeopardy yet, but continued adverse trends may cause it to be.  Typical characteristics of Watch assets include:  increasing debt; liquidity problems; negative trends in operating cash flow; collateral dependent with advances outside policy guidelines; and/or sporadic payment performance.

Substandard:  A Substandard loan is inadequately protected by the current sound net worth and paying capacity of the borrower or of the collateral pledged, if any.  These loans have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt and have a distinct possibility that the Company may sustain some loss if the deficiencies are not corrected.

Nonaccrual: Loans in this category have the same characteristics as those classified Substandard with the added characteristic that further erosion in the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.  The likelihood of loss is yet to be fully determined due to the borrower’s inability or refusal to provide updated financial information, appraisals or additional collateral.

Doubtful:  Loans in this category have the weaknesses of those classified Substandard where collection and/or liquidation in full, on the basis of currently existing conditions, is highly questionable or improbable.  Treatment as “loss” is deferred until exact status can be determined.

Loss:  Loans classified loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted.  This classification does not mean that the loan has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless loan even though partial recovery may be affected in the future.

17

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

Below shows the allocation of the allowance for loan and lease losses by segment to loans and leases individually and collectively evaluated for impairment:

					Allowance				Allowance
					for Loan				for Loan
					Losses				Losses
	Ending				Allocated to				Allocated to
	Balance		Loans		Loans		Loans		Loans
`	Total		Individually		Individually		Collectively		Collectively
	Loans		Evaluated		Evaluated		Evaluated		Evaluated
	and		for		for		for		for
At March 31, 2012  ($000's)	Leases		Impairment		Impairment		Impairment		Impairment
Commercial	$	15,523	$	647	$	612	$	14,876	$	500
Real estate-construction		27,811		14,262		956		13,549		897
Real estate-mortgage 1-4 family		34,155		4,264		368		29,891		485
Real estate-mortgage 5+ family		35,621		3,983		0		31,638		1,714
Real estate-mortgage commercial		181,610		53,766		9,394		127,844		3,313
Home equity		20,740		761		345		19,979		428
Leases		259		0		0		259		0
Installment		1,355		0		0		1,355		14
Balance at March 31, 2012	$	317,074	$	77,683	$	11,675	$	239,391	$	7,351

					Allowance				Allowance
					for Loan				for Loan
					Losses				Losses
	Ending				Allocated to				Allocated to
	Balance		Loans		Loans		Loans		Loans
	Total		Individually		Individually		Collectively		Collectively
	Loans		Evaluated		Evaluated		Evaluated		Evaluated
	and		for		for		for		for
At December 31, 2011  ($000's)	Leases		Impairment		Impairment		Impairment		Impairment
Commercial	$	15,827	$	655	$	273	$	15,172	$	519
Real estate-construction		28,504		6,876		2,044		21,628		1,105
Real estate-mortgage 1-4 family		35,758		5,163		396		30,595		469
Real estate-mortgage 5+ family		35,977		3,987		0		31,990		1,646
Real estate-mortgage commercial		183,881		54,074		8,561		129,807		3,457
Home equity		21,266		443		141		20,823		359
Leases		295		0		0		295		0
Installment		1,476		0		0		1,476		14
Balance at December 31, 2011	$	322,984	$	71,198	$	11,415	$	251,786	$	7,569

18

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

Below shows the age analysis of the past due loans and leases by segment and class at March 31, 2012 and December 31, 2011:

													Greater
													Than
													90 Days Past
At March 31, 2012 ($000's)							Greater				Total		Due and
			30-59 Days		60-89 Days		Than 90 Days		Total		Loans and		Still
	Current		Past Due		Past Due		Past Due		Past Due		Leases		Accruing
Commercial	$	14,889	$	92	$	0	$	542	$	634	$	15,523	$	0
Real estate-construction
1-4 family		9,824		60		0		5,953		6,013		15,837		4,230
Other		10,022		68		0		1,884		1,952		11,974		0
Real estate-mortgage
1-4 family		32,070		548		108		1,429		2,085		34,155		474
Real estate-mortgage
5+ family		30,445		1,193		0		3,983		5,176		35,621		0
Real estate-mortgage commercial
Owner occupied		52,887		603		0		7,901		8,504		61,391		50
Non-owner occupied		70,388		951		0		2,081		3,032		73,420		1,057
Hotel industry		46,799		0		0		0		0		46,799		0
Home equity		19,552		431		58		699		1,188		20,740		0
Leases		259		0		0		0		0		259		0
Installment		1,319		21		0		15		36		1,355		15
Balance at March 31, 2012	$	288,454	$	3,967	$	166	$	24,487	$	28,620	$	317,074	$	5,826

													Greater
													Than
													90 Days Past
At December 31, 2011 ($000's)							Greater				Total		Due and
			30-59 Days		60-89 Days		Than 90 Days		Total		Loans and		Still
	Current		Past Due		Past Due		Past Due		Past Due		Leases		Accruing
Commercial	$	15,273	$	6	$	0	$	548	$	554	$	15,827	$	0
Real estate-construction
1-4 family		14,084		0		0		2,716		2,716		16,800		152
Other		9,820		0		0		1,884		1,884		11,704		0
Real estate-mortgage
1-4 family		32,539		1,672		284		1,263		3,219		35,758		0
Real estate-mortgage
5+ family		32,227		0		0		3,750		3,750		35,977		0
Real estate-mortgage commercial
Owner occupied		53,911		265		471		7,850		8,586		62,497		0
Non-owner occupied		73,162		575		227		450		1,252		74,414		0
Hotel industry		46,970		0		0		0		0		46,970		0
Home equity		20,288		206		71		701		978		21,266		322
Leases		295		0		0		0		0		295		0
Installment		1,442		15		3		16		34		1,476		16
Balance at December 31, 2011	$	300,011	$	2,739	$	1,056	$	19,178	$	22,973	$	322,984	$	490

19

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

The Company utilizes a loan rating system as a means of identifying problem and potential loans.  Below shows the loan ratings of loans and leases by segment and class at March 31, 2012 and December 31, 2011:

At March 31, 2012 ($000's)	Pass		Watch		Substandard		Nonaccrual		Total
Commercial	$	12,247	$	2,622	$	112	$	542	$	15,523
Real estate-construction
1-4 Family		2,222		168		11,724		1,723		15,837
Other		490		2,647		6,953		1,884		11,974
Real estate-mortgage 1-4 family		25,007		5,020		3,174		954		34,155
Real estate-mortgage 5+ family		24,783		6,855		0		3,983		35,621
Real estate-mortgage commercial
Owner occupied		30,827		12,838		9,876		7,850		61,391
Non-owner occupied		40,545		17,984		13,866		1,025		73,420
Hotel industry		3,754		9,219		33,826		0		46,799
Home equity		18,556		793		628		763		20,740
Leases		259		0		0		0		259
Installment		1,355		0		0		0		1,355
Balance at March 31, 2012	$	160,045	$	58,146	$	80,159	$	18,724	$	317,074

At December 31, 2011 ($000's)	Pass		Watch		Substandard		Nonaccrual		Total
Commercial	$	12,587	$	2,247	$	445	$	548	$	15,827
Real estate-construction
1-4 Family		2,345		4,230		7,662		2,563		16,800
Other		277		6,602		2,941		1,884		11,704
Real estate-mortgage 1-4 family		25,430		4,968		4,097		1,263		35,758
Real estate-mortgage 5+ family		25,105		6,885		0		3,987		35,977
Real estate-mortgage commercial
Owner occupied		31,778		12,211		10,186		8,322		62,497
Non-owner occupied		41,096		20,031		12,837		450		74,414
Hotel industry		3,784		9,358		33,828		0		46,970
Home equity		19,527		792		504		443		21,266
Leases		247		48		0		0		295
Installment		1,476		0		0		0		1,476
Balance at December 31, 2011	$	163,652	$	67,372	$	72,500	$	19,460	$	322,984

20

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

The following tables present loans and leases by segment and class individually evaluated for impairment at March 31, 2012 and December 31, 2011 and the average recorded investment and investment income recognized for the three months ended March 31, 2012 and for the year ended December 31, 2011:

($000's)							For the Three Months
	At March 31. 2012						Ended March 31, 2012
			Unpaid				Average		Investment
	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized
With no related allowance recorded:
Commercial	$	0	$	0	$	0	$	0	$	0
Real estate-construction
1-4 family		5,953		7,181		0		3,693		0
Other		4,746		6,479		0		2,071		0
Real estate-mortgage 1-4 family		2,072		2,072		0		1,897		13
Real estate-mortgage 5+ family		3,983		3,983		0		3,984		0
Real estate-mortgage commercial
Owner occupied		3,879		3,879		0		4,193		41
Non-owner occupied		4,403		4,403		0		4,085		33
Hotel industry		6,151		6,151		0		6,153		74
Home equity		30		30		0		63		0
Leases		0		0		0		0		0
Installment		0		0		0		0		0
With an allowance recorded:
Commercial		647		1,408		612		652		0
Real estate-construction
1-4 family		2,413		2,413		873		2,413		27
Other		1,150		1,150		83		1,150		0
Real estate-mortgage 1-4 family		2,192		2,192		368		2,326		14
Real estate-mortgage 5+ family		0		0		0		0		0
Real estate-mortgage commercial
Owner occupied		10,916		10,916		3,135		10,919		39
Non-owner occupied		8,661		8,661		585		8,662		93
Hotel industry		19,756		23,355		5,674		19,756		193
Home equity		731		731		345		561		0
Leases		0		0		0		0		0
Installment		0		0		0		0		0
Total:
Commercial	$	647	$	1,408	$	612	$	652	$	0
Real estate-construction		14,262		17,223		956		9,327		27
Real estate-mortgage 1-4 family		4,264		4,264		368		4,223		27
Real estate-mortgage 5+ family		3,983		3,983		0		3,984		0
Real estate-mortgage commercial		53,766		57,365		9,394		53,768		473
Home equity		761		761		345		624		0
Leases		0		0		0		0		0
Installment		0		0		0		0		0
Total	$	77,683	$	85,004	$	11,675	$	72,578	$	527

21

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

($000's)							For the Year
	At December 31. 2011						Ended December 31, 2011
			Unpaid				Average		Investment
	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized
With no related allowance recorded:
Commercial	$	0	$	0	$	0	$	152	$	0
Real estate-construction
1-4 family		34		34		0		4,607		176
Other		734		2,468		0		1,109		0
Real estate-mortgage 1-4 family		2,039		2,039		0		3,391		96
Real estate-mortgage 5+ family		3,987		3,987		0		8,856		38
Real estate-mortgage commercial
Owner occupied		5,254		5,254		0		6,333		185
Non-owner occupied		3,927		3,927		0		10,281		408
Hotel industry		3,034		3,034		0		2,758		132
Home equity		30		30		0		67		20
Leases		0		0		0		0		0
Installment		0		0		0		0		0
With an allowance recorded:
Commercial		655		1,416		273		1,026		1
Real estate-construction
1-4 family		4,958		4,958		1,960		4,861		103
Other		1,150		1,150		84		1,150		22
Real estate-mortgage 1-4 family		3,124		3,124		396		2,899		131
Real estate-mortgage 5+ family		0		0		0		0		0
Real estate-mortgage commercial
Owner occupied		10,319		10,319		2,974		9,549		97
Non-owner occupied		746		746		458		746		2
Hotel industry		30,794		34,393		5,129		31,523		1,139
Home equity		413		413		141		1,621		2
Leases		0		0		0		0		0
Installment		0		0		0		6		1
Total:
Commercial	$	655	$	1,416	$	273	$	1,178	$	1
Real estate-construction		6,876		8,610		2,044		11,727		301
Real estate-mortgage 1-4 family		5,163		5,163		396		6,290		227
Real estate-mortgage 5+ family		3,987		3,987		0		8,856		38
Real estate-mortgage commercial		54,074		57,673		8,561		61,190		1,963
Home equity		443		443		141		1,688		22
Leases		0		0		0		0		0
Installment		0		0		0		6		1
Total	$	71,198	$	77,292	$	11,415	$	90,935	$	2,553

22

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

The following table presents the number of loans and leases modified as TDRs by segment and class during the three month period ended March 31, 2012, the outstanding recorded balances at the time modified and the outstanding recorded investment balances at March 31, 2012:

At March 31, 2012 ($000's)	Troubled Debt Restructurings
			Pre-Modification		Post-Modification
			Outstanding		Outstanding
	Number of		Recorded		Recorded
Troubled Debt Restructurings	Loans		Investment		Investment
Commercial		1	$	109	$	106
Real estate-construction
1-4 family		2		4,230		4,230
Other		1		4,012		4,012
Real estate-mortgage 1-4 family		13		1,777		1,770
Real estate-mortgage 5+ family		0		0		0
Real estate-mortgage commercial
Owner occupied		5		4,909		4,895
Non-owner occupied		2		2,755		2,753
Hotel industry		1		5,433		5,500
Home equity		0		0		0
Leases		0		0		0
Installment		0		0		0
Total		25	$	23,225	$	23,266

23

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

The following table presents the number of loans and leases modified as TDRs by segment and class during the twelve month period ended March 31, 2012 that subsequently defaulted during the three month period ended March 31, 2012 and the outstanding recorded investment balance at March 31, 2012.  For disclosure in this table, defaulted TDRs are those TDR loans greater than 90 days or more past due and still accruing or on nonaccrual status.

March 31, 2012 ($000s)	Troubled Debt Restructurings that Subsequently Defaulted
Troubled Debt Restructurings	Number of Loans		Recorded Investment
Commercial		0	$	0
Real estate-construction
1-4 Family		2		4,230
Other		0		0
Real estate-mortgage 1-4 family		0		0
Real estate-mortgage 5+ family		0		0
Real estate-mortgage commercial
Owner occupied		1		412
Non-owner occupied		0		0
Hotel industry		0		0
Home equity		0		0
Leases		0		0
Installment		0		0
Total at March 31, 2012		3	$	4,642

24

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

Note 7 - Fair Value Measurement

The table below shows information about the Company's securities that were measured at fair value and the valuation techniques used by the Company to determine fair values.

In general, fair values determined by Level 1 inputs use a quoted price in active markets for identical securities that the Company had the ability to access.

Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly.  These Level 2 inputs include quoted prices for similar securities in active markets, and other input such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related securities.

In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest input that is significant to the valuation.  The Company's assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each security.

On an annual basis the Company validates the measurement of the fair values of its securities with an independent securities valuation firm. This independent securities valuation firm determines the fair values of the securities portfolio that is then compared to the fair value using the methods outlined.  When this validation was last done on September 30, 2011, the difference between the fair value reported and the fair value determined by the independent securities valuation firm was considered immaterial.

25

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

Securities Available for Sale ($000's)			Fair Value Measurements at Reporting Date Using
			Quoted Prices
			in Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
States and political subdivisions	$	2,984	$	0	$	2,167	$	817
Mortgage-backed securities		77,995		0		77,995		0
Equity securities		4,253		4,253		0		0
At March 31, 2012	$	85,232	$	4,253	$	80,162	$	817
States and political subdivisions	$	3,117	$	0	$	2,172	$	945
Mortgage-backed securities		79,762		0		79,762		0
Equity securities		4,261		4,261		0		0
At December 31, 2011	$	87,140	$	4,261	$	81,934	$	945

26

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

The Company's change in Level 3 securities measured at fair value on a recurring basis was as follows:

	Securities
	Available
	for Sale ($000's)
Balance at December 31, 2011	$	945
Total realized and unrealized gains (losses) included in income		0
Total unrealized gains (losses) included in other comprehensive income		0
Net purchase, sales, calls and maturities		(128	)
Net transfer into Level 3		0
Balance at March 31, 2012	$	817

	Securities
	Available
	for Sale ($000's)
Balance at December 31, 2010	$	20
Total realized and unrealized gains (losses) included in income		(163	)
Total unrealized gains (losses) included in other comprehensive income		143
Net purchase, sales, calls and maturities		0
Net transfer into Level 3		0
Balance at March 31, 2011	$	0

At year-end 2011, the Company had nonrated securities issued by a local municipality totaling $945,000 in which the fair value was determined using significant unobservable inputs, or Level 3, based on an outside investment broker’s analysis of the financial condition of the municipality issuing the securities. During the three months ended March 31, 2012, $128,000 of these Level 3 securities matured.

The Company used accounting guidelines to determine other than temporary impairment losses on its Collateralized Debt Obligations ("CDOs") as the fair value of these securities was not readily determinable by the market.  The impairment losses on the CDOs were due to defaults and deferrals of payments by the financial institutions and insurance companies that issued the debt underlying the securities. During the quarter ended March 31, 2011, the Company used cash flow analyses on its CDOs to determine other than temporary impairment losses of $134,000, fully writing off the remaining book value of these securities.

During the quarter ended March 31, 2011, the Company recognized other than temporary impairment losses on its equity securities consisting of preferred stock issued by the Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”) of $29,000, fully writing off the remaining book value of these securities.

The Company also has assets that under certain conditions are subject to measurement at fair value on a nonrecurring basis.  These assets are held to maturity loans or other real estate owned that are considered impaired per accounting principles.  The Company has estimated the fair value of these impaired assets using Level 3 inputs, specifically discounted cash flow projections or fair value of collateral.

27

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

During the three months ended March 31, 2012 and 2011, the Company recorded adjustments to certain collateral dependent loans that were measured for impairment in accordance with accounting guidelines.  In cases where the carrying value of the loans exceed the estimated fair value of the collateral less estimated costs to sell, an impairment loss was recognized.  The Company also recorded adjustments to certain cash flow dependent loans consisting primarily of troubled debt restructured loans that were measured for impairment in accordance with accounting guidelines.  In the case of cash flow dependent troubled debt restructured loans, impairment was determined by comparing the discounted cash flows with the Company’s recorded investment.  The Company made allocations for impaired loans totaling $1.6 million and $1.8 million for the three months ended March 31, 2012 and 2011, respectively.

Impaired Loans ($000's)			Fair Value Measurements at Reporting Date Using
			Quoted Prices
			in Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
At March 31, 2012	$	34,791	$	0	$	0	$	34,791
At December 31, 2011	$	40,744	$	0	$	0	$	40,744

Impaired Other Real Estate Owned ($000's)			Fair Value Measurements at Reporting Date Using
			Quoted Prices
			in Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
At March 31, 2012	$	16,699	$	0	$	0	$	16,699
At December 31, 2011	$	18,300	$	0	$	0	$	18,300

During the quarter ended March 31, 2012, the Company recorded adjustments of $1,972,000 to certain properties carried as other real estate owned as compared to adjustments of $673,000 for the same quarter of 2011.  Such write-downs are generally based on the estimated underlying fair values of the properties less estimated costs to sell.  In cases where the carrying value of the property exceeds the estimated fair value, an impairment loss is recognized.

The following methods and assumptions were used to estimate fair values for financial instruments.  Securities fair values are based on quoted market prices or, if no quotes are available, on the rate and term of the security and/or information about the issuer.  For loans, leases, deposits, securities sold under repurchase agreements and fixed-rate FHLB advances, the fair value is estimated by discounted cash flow analysis using market rates for the estimated life and credit risk.  Fair values for impaired loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.  The fair value of off-balance sheet items is based on the fees or cost that would currently be charged to enter into or terminate such arrangements, and the amount is not considered material.  Fair value for cash and cash equivalents, accrued interest receivable, advances from borrowers for taxes and insurance and accrued interest payable are estimated at carrying value. The estimated fair value for Federal Home Loan Bank stock is equal to the carrying value based on the restricted nature of the stock.

28

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

The estimated fair values of financial instruments at March 31, 2012 and December 31, 2011 were:

	Carrying			Estimated
March 31, 2012  ($000's)	Value			Fair Value
Financial assets:
Cash and cash equivalents	$	37,367		$	37,367
Securities available for sale		85,232			85,232
Loans and leases, net		297,807			307,365
Federal Home Loan Bank stock		1,434			1,434
Accrued interest receivable		1,481			1,481
Financial liabilities:
Deposits	$	(391,837	)	$	(391,947	)
Securities sold under repurchase agreements		(16,639	)		(16,603	)
Subordinated debentures		(10,310	)		(4,706	)
Advances from borrowers for taxes and insurance		(1,960	)		(1,960	)
Accrued interest payable		(1,083	)		(1,083	)

	Carrying			Estimated
December 31, 2011  ($000's)	Value			Fair Value
Financial assets:
Cash and cash equivalents	$	37,833		$	37,833
Securities available for sale		87,140			87,140
Loans and leases, net		303,729			313,338
Federal Home Loan Bank stock		1,801			1,801
Accrued interest receivable		1,401			1,401
Financial liabilities:
Deposits	$	(397,631	)	$	(397,885	)
Securities sold under repurchase agreements		(19,455	)		(19,417	)
Subordinated debentures		(10,310	)		(4,375	)
Advances from borrowers for taxes and insurance		(1,222	)		(1,222	)
Accrued interest payable		(1,127	)		(1,127	)

29

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

Note 8 – Consent Order and Written Agreement

On April 16, 2010, the Company’s wholly-owned subsidiary, NorStates Bank (the “Bank”), and the Federal Deposit Insurance Corporation (the “FDIC”) and the Illinois Department of Financial and Professional Regulation (the “IDFPR”) entered into a joint Consent Order.  Pursuant to the Consent Order, among other things, the Bank has agreed to undertake the following:

(1) increase the participation of the Bank’s Board of Directors in overseeing and supervising the affairs and activities of the Bank, including holding meetings of the Board no less frequently than monthly;

(2) adopt and implement a program for monitoring compliance with the Consent Order, including establishing a committee comprised of at least three outside Bank board members responsible for such oversight;

(3) maintain a Tier 1 capital to total assets ratio of at least 8% and a total risk-based capital ratio of at least 12%;

(4) prohibit the extension of additional credit to or for the benefit of any existing borrower with a loan that has been previously charged-off or classified “loss” by the examiners, as well as prohibit the extension of additional credit in any amount in excess of $10,000 to any existing borrower with an outstanding loan classified as “substandard”, “doubtful” or “special mention” unless the Board of Directors or a committee thereof determines the loan to be in the best interests of the Bank;

(5) adopt a written action plan with respect to each classified asset and delinquent loan in excess of $1,000,000 for the purpose of reducing the Bank’s risk position with respect to such asset;

(6) correct all deficiencies in the loans listed as “special mention” by the examiners;

(7) adopt a written action plan to reduce and manage concentrations of credit identified by the examiners, including procedures that provide for the ongoing measurement and monitoring of the concentrations of credit, the performance of portfolio stress testing analysis and the setting of concentration limits commensurate with the Bank’s capital levels and overall risk profile;

(8) provide for quarterly reviews of and adjustments to the allowance for loan and lease losses in accordance with bank regulatory guidelines;

(9) implement revised written lending and collection policies as indicated by the examiners, as well as revised loan grading and review procedures, including procedures for periodic confirmation of the accuracy and completeness of the watch list and all risk grade assignments, identification of loan relationships that warrant special management attention, and identification and tracking of credit and collateral documentation exceptions;

(10) adopt a written profit plan and comprehensive budget containing formal goals and strategies to reduce discretionary expenses and to improve the Bank’s overall earnings;

(11) adopt a written contingency funding/liquidity plan which includes identification of the sources of liquid assets available to meet the Bank’s contingency funding needs over one-, two- and three-month time horizons; and

(12) adopt a revised investment policy and interest rate risk policy to address the recommendations of the examiners.

30

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

The Consent Order also prohibits the payment of any dividends by the Bank to the Company without the prior written consent of both the FDIC and the IDFPR.

Because the Consent Order establishes specific capital amounts to be maintained by the Bank, the Bank may not be considered better than “adequately capitalized” for capital adequacy purposes, even if the Bank exceeds the levels of capital set forth in the Consent Order. Currently, the Bank exceeds the capital levels established by the FDIC and the IDFPR in the Consent Order.

As an adequately capitalized institution, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC.  Brokered deposits also include deposits with rates of interest that are more than 75 basis points above the rates applicable to the market of the Bank as determined by the FDIC.  The FDIC has approved that the Bank is operating in a high rate area, which allows the Bank to use local average deposit rates as a basis for setting competitive rates on its deposits.

Any material failure to comply with the provisions of the Consent Order could result in additional enforcement actions by the FDIC as allowed by 12 U.S.C. §1818 and the IDFPR. While the Company intends to take such actions as may be necessary to enable the Bank to comply with the requirements of the Consent Order, there can be no assurance that the Bank will be able to comply fully with the provisions of the Consent Order, or that efforts to comply with the Consent Order will not have adverse effects on the operations and financial condition of the Company and the Bank.

On March 17, 2011, the Company and the Federal Reserve Bank of Chicago (“Reserve Bank”) entered into a Written Agreement.  Pursuant to the Written Agreement, among other things, the Company has agreed to undertake the following:

1) serve as a source of strength to the Bank;

2) abstain from paying any dividends, redeeming any stock or incurring any debt without Federal Reserve approval;

3) adopt a capital plan;

4) provide the Federal Reserve with cash flow projections on a quarterly basis;

5) notify the Federal Reserve of the proposed addition of any individual to the Board of Directors or the employment of any individual as a senior executive officer of the Company before such addition or employment becomes effective; and

6) provide progress reports to the Federal Reserve concerning the Company’s compliance with the Written Agreement.

Any material failure to comply with the provisions of the Written Agreement could result in additional enforcement actions by the Federal Reserve Bank. While the Company intends to take such actions as may be necessary to comply with the requirements of the Written Agreement, there can be no assurance that the Company will be able to comply fully with the provisions of the Written Agreement, or that efforts to comply with the Written Agreement will not have adverse effects on the operations and financial condition of the Company.

31

NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2012

(Unaudited)

Note 9 – Management Plans

Management and the Board of Directors are committed to complying with the terms of the Consent Order and the Written Agreement, and have already taken, and continue to take, numerous steps to address these matters.  The Bank and the Company reports to the FDIC and the IDFPR, and the Federal Reserve, respectively, quarterly regarding their progress in complying with the provisions included in the Consent Order and the Written Agreement.  Compliance with the terms of the Consent Order and the Written Agreement will be an ongoing priority for management of the Bank and the Company.

The Bank continues to dedicate significant resources to effectively identify, monitor, and manage problem assets and reduce real estate loan concentrations.  A liquidity policy has been developed to identify the sources of liquid assets available to meet the Bank’s contingency funding needs.  Dividends have already been restricted and the Company has suspended its dividend payments on its Series A Preferred Stock issued to the Treasury Department as is permissible under the terms of the TARP Capital Purchase Program and has deferred payment of interest on its subordinated debentures.  The Bank’s Tier 1 to average assets ratio and total capital to assets ratio, on a risk adjusted basis, were 8.23 percent and 13.30 percent, respectively, as of March 31, 2012, which were above the capital levels required by the Consent Order of 8.00 percent and 12.00 percent.

In view of these matters, the Bank’s ability to improve its financial condition is dependent upon the success of management’s plans to address concerns regarding profitability and asset quality.  The Bank’s management believes they are taking appropriate steps aimed at returning the Bank to profitability and improving asset quality.  Management’s success will ultimately be determined by its implementation of its plans, as well as factors beyond its control, such as the economy and real estate market.

Note 10 – Recent Accounting Pronouncements

(ASU No. 2011-2)  In April 2011, the FASB issued “Receivables (Topic 310) - A Creditor's Determination of Whether a Restructuring is a Troubled Debt Restructuring.” ASU 2011-2 provides additional guidance to assist creditors in determining whether a restructuring of a receivable meets the criteria to be considered a troubled debt restructuring.  The impact of ASU 2011-2 on the Company’s disclosure is reflected in Note 6 to the condensed consolidated financial statements.

(ASU 2011-4) In May 2011, the FASB issued an Update related to fair value measurements (Topic 820) and disclosure requirements.  The Update results in common fair value measurement and disclosures in U.S. GAAP and IFRS by changing the wording used to describe many of the fair value measurement requirements in U.S. GAAP or to clarify the FASB’s intent about the application of existing fair value measurement requirements.    The amendments were adopted beginning in the first quarter of 2012 and applied to the Company’s financial statements prospectively.

(ASU 2011-5) In June 2011, the FASB issued an Update on the Presentation of Comprehensive Income (Topic 220), which was amended in October 2011.  The Update changes the reporting and presentation of comprehensive income on the face of the financial statements and provides two options of presentation- a single statement including net income and the components of other comprehensive income or two separate statements.  The Update eliminates the option of presenting the components of other comprehensive income in the statement of changes in stockholders’ equity.  The amendments in this Update were adopted beginning in the first quarter of 2012 and will be applied to the Company’s financial statements retrospectively.

32

NORTHERN STATES FINANCIAL CORPORATION

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following discussion focuses on the consolidated financial condition of Northern States Financial Corporation (the “Company”) at March 31, 2012 compared to December 31, 2011 and the Company’s consolidated results of operations for the three month period ended March 31, 2012, compared with the three month period ended March 31, 2011.  The purpose of this discussion is to provide a better understanding of the condensed consolidated financial statements of the Company and the operations of its two wholly-owned subsidiaries, NorStates Bank (the “Bank”) and NorProperties, Inc. (“NorProp”), and the Bank’s wholly-owned subsidiary, Northern States Community Development Corporation (“NSCDC”). This discussion should be read in conjunction with the interim condensed consolidated unaudited financial statements and notes thereto included herein.

Statements contained in this report that are not historical facts may constitute forward-looking statements (within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended), which involve significant risks and uncertainties.  The Company intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and is including this statement for purposes of invoking these safe harbor provisions.  Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are generally identifiable by the use of the words "believe," "expect," "intend," "anticipate," "estimate," "project," "plan," or similar expressions.  The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain and actual results may differ from those predicted.  The Company undertakes no obligation to update these forward-looking statements in the future.  The Company cautions readers of this report that a number of important factors could cause the Company’s actual results subsequent to March 31, 2012 to differ materially from those expressed in forward-looking statements.  Factors that could cause actual results to differ from those predicted and could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, the potential for further deterioration in the credit quality of the Company’s loan and lease portfolios, uncertainty regarding the Company’s ability to ultimately recover on loans currently on nonaccrual status, the Company’s ability to comply with the provisions of the Consent Order and Written Agreement, further deterioration in the value of the Company’s other real estate owned, unanticipated changes in interest rates, worsening or lack of improvement in general economic conditions and the real estate market, increasing regulatory compliance burdens or potential legislative/regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the quality or composition of the Company’s loan or investment portfolios, deposit flows, liquidity issues, competition, demand for loan products and financial services in the Company’s market area, and changes in accounting principles, policies and guidelines.  These risks and uncertainties should be considered in evaluating forward-looking statements.

OVERVIEW

Total assets at March 31, 2012 were $453.0 million, a decrease of $10.0 million, or 2.2 percent, from $463.0 million at December 31, 2011 as the Company continued to reposition its balance sheet.  Loans totaled $316.8 million at March 31, 2012, a decrease of $5.9 million, or 1.8 percent, from $322.7 million at December 31, 2011.  Loans decreased by $3.0 million as scheduled principal loan payments and loan payoffs were received in the normal course of business.  Contributing to the decrease in loans was the transfer of $1.5 million in loans to other real estate owned through or in lieu of foreclosure and the charge-off of $1.4 million in loans to the allowance for loan and lease losses. Other real estate owned totaled $17.9 million at March 31, 2012, decreasing $1.4 million from year-end 2011 as $964,000 of properties were sold and the Company recognized further impairment of $2.0 million, partially offset by the transfer of $1.5 million in loans to other real estate owned.  The Company’s cash and cash equivalents totaled $37.4 million at March 31, 2012, showing a slight decrease of $466,000 from December 31, 2011.

33

NORTHERN STATES FINANCIAL CORPORATION

The decline in the Company’s assets was primarily offset by deposit decreases of $5.8 million, or 1.5%. Deposits totaled $391.8 million at March 31, 2012 compared with $397.6 million at December 31, 2011.  Time deposits decreased $20.4 million while total other deposits consisting of demand, interest bearing demand, money market and savings deposits increased $14.6 million from December 31, 2011.  Time deposits decreased primarily from reductions of $1.7 million in brokered time deposits and $14.6 million in wholesale internet time deposits.

The Company’s borrowings through securities sold under repurchase agreements decreased $2.8 million to $16.6 million at March 31, 2012 as compared with $19.4 million at December 31, 2011.

The Company continued to be affected by the continued decline in general real estate prices.  For the three months ended March 31, 2012, the Company experienced a net loss available to common stockholders of $3.1 million or $0.73 per share, compared with a net loss of $1.4 million, or $0.32 per share for the same three months of 2011 as the Company continued to write down loans and other real estate owned as a result of declining values of the collateral securing those assets.  The provision for loan and lease losses increased $200,000 and write-downs of other real estate owned increased $1.3 million during the first quarter of 2012 as compared to the same quarter of 2011.  Losses on the sale of other real estate owned were $216,000 during the first quarter of 2012 as compared with gains of $67,000 during the same quarter last year.

Total nonperforming loans and leases increased $7.6 million to $79.3 million, or 25.0 percent of total loans and leases, at March 31, 2012 as compared with $71.7 million, or 22.2 percent of total loans and leases, at December 31, 2011.

The Company’s net interest income, the difference between interest earned on loans and investments and interest paid on deposits and borrowings, was $4.3 million for the first quarter of 2012 decreasing 7.8 percent, or $364,000 compared with the same quarter of 2011. The decline in net interest income was attributable to a decrease in average earning assets of $70.9 million and the high levels of nonperforming loans.

Noninterest expenses for the Company, other than write-downs to other real estate owned, decreased $307,000 during the first quarter of 2012 as compared with the same quarter of 2011 as management focused on controlling costs.

CRITICAL ACCOUNTING POLICIES

Certain critical accounting policies involve estimates and assumptions by management.  To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information.  These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ.

The allowance for loan and lease losses is a valuation allowance for probable incurred credit losses that is increased by the provision for loan and lease losses and decreased by charge-offs less recoveries. Management estimates the balance for the allowance based on information about specific borrower situations, estimated collateral values, discounted cash flows and the borrowers’ ability to repay the loan. Management also reviews past loan and lease loss experience, the nature and volume of the portfolio, environmental and qualitative factors, economic conditions and other factors which may affect the repayment of loans. Allocations of the allowance may be made for specific loans and leases, but the entire allowance is available for any loan or lease that, in management’s judgment, should be charged-off. Loan and lease losses are charged against the allowance when management believes the uncollectibility of a loan or lease balance is confirmed.

34

NORTHERN STATES FINANCIAL CORPORATION

A loan or lease is impaired when full payment under the loan or lease terms is not expected within the contractual terms of the loan. Impairment is evaluated on an aggregate basis for smaller-balance loans of similar nature such as residential mortgage and consumer loans, and on an individual loan or lease basis for other loans and leases. If a specific loan or lease is determined to be impaired, a portion of the allowance may be specifically allocated to that loan or lease. The specific allocation is calculated at the present value of estimated cash flows using the existing rate of the loan or lease or the fair value of collateral if repayment is expected solely from the collateral.

Other real estate owned consists of properties securing nonperforming loans obtained through, or in lieu of, foreclosure and is initially reported at the estimated fair value based on a real estate appraisal less estimated costs to sell. Other real estate is periodically assessed for impairment and any such impairment is recognized in the current period.

The fair value of securities is based on determinations from a securities broker. On an annual basis these are validated by an independent securities valuation firm. This validation was last done at September 30, 2011 and the differences in fair value were deemed to be immaterial.

There are various contingent liabilities that are not reflected in the financial statements, including claims and legal actions arising against the Company in the ordinary course of business. These matters are not expected to have a material effect on the Company’s operating results or financial condition.

The fair value of financial instruments such as cash and cash equivalents, accrued interest receivable, advances from borrowers for taxes and insurance and accrued interest payable are estimated at carrying value. The estimated fair value for Federal Home Loan Bank stock is equal to the carrying value based on the restricted nature of the stock.

The Company recognized no income tax benefit for the three months ended March 31, 2012 despite having an operating loss before income taxes of $2.8 million.  Per accounting rules, the Company continued to book tax benefits adjusted for timing differences as a deferred tax asset with a corresponding offset to the deferred tax asset valuation allowance, without recognizing a tax benefit on the income statement due to uncertainties as to the realization of these benefits.  For the three months ended March 31, 2012, the Company’s tax benefit was calculated to be $1.1 million and the deferred tax asset increased to $21.6 million exclusive of the deferred tax effect of the unrealized gains of the Company’s securities.  The Company will continue to analyze its deferred tax assets quarterly.

FINANCIAL CONDITION

The Company’s cash and cash equivalents totaled $37.4 million at March 31, 2012, slightly increasing from December 31, 2011.  The Company’s interest bearing deposits in financial institutions with maturities less than 90 days, a component of cash and cash equivalents, totaled $29.9 million, a decrease of $2.6 million from December 31, 2011.  These funds consisted primarily of deposits at the Federal Reserve Bank of Chicago as the interest rate paid was greater than or comparable to rates paid on federal funds sold.

The Company’s securities available for sale declined $1.9 million, to $85.2 million at March 31, 2012 compared with $87.1 million at year-end 2011.  The declines in securities were due to the receipt of scheduled maturities and payments.   At March 31, 2012, the Company had pledged securities of $51.2 million as compared to $57.0 million at December 31, 2011.  The securities were pledged to secure public deposits, repurchase agreements and for other purposes as required or permitted by law.

Loans and leases totaled $316.8 million at March 31, 2012, decreasing $5.9 million, or 1.8 percent, from $322.7 million at December 31, 2011.  Loans decreased by $3.0 million as scheduled principal loan payments and loan payoffs were received in the normal course of business.  Contributing to the decrease in loans was the transfer of $1.5 million in loans to other real estate owned through or in lieu of foreclosure, and the charge-off of $1.4 million in loans to the allowance for loan and lease losses.

35

NORTHERN STATES FINANCIAL CORPORATION

At March 31, 2012, approximately 95 percent of the Bank’s loan portfolio was secured by real estate.  The Company’s loans to the hotel industry totaled $46.8 million, or 183 percent of total capital at March 31, 2012, decreasing slightly from $47.0 million, or 165 percent of capital at year-end 2011.  Loans totaling $26.1 million secured by 1-4 family homes and 5+ family residences at March 31, 2012 were pledged to secure a line of credit of $14.3 million from the Federal Home Loan Bank of Chicago.  At March 31, 2012, loans totaling $79.3 million had payment schedules where only interest is collected until the loans mature as compared with $96.1 million in loans at December 31, 2011.  At March 31, 2012, $19.0 million of loans having interest only payments were home equity loans.

Loan commitments declined $1.2 million to $31.0 million at March 31, 2012, compared with $32.2 million at December 31, 2011.  Letters of credit decreased during the nine months ended March 31, 2012, to $1.7 million from $2.3 million at year-end 2011.

At March 31, 2012, loans to related parties totaled $119,000 as compared with $238,000 at December 31, 2011.  Loan commitments and letters of credit issued to related parties were $95,000 at March 31, 2012 compared with $247,000 at December 31, 2011.  Loans, loan commitments and letters of credit to related parties are made on the same terms and conditions that are available to the public.

The decline in the Company’s assets was primarily offset by deposit decreases of $5.8 million. Deposits totaled $391.8 million at March 31, 2012 compared with $397.6 million at December 31, 2011.  Time deposits decreased $20.4 million as management reduced its dependence on wholesale internet time deposits by $14.6 million and lowered its brokered time deposits by $1.7 million.  Offsetting some of the decline were increases to demand deposits of $2.7 million, interest bearing demand deposits (“NOW”) of $6.7 million and low cost savings accounts of $5.9 million.  Related party deposits at March 31, 2012 totaled $1.5 million as compared with $2.1 million at year-end 2011.

At March 31, 2012, the mix of deposits changed as retail deposits increased $10.6 million to 72.1 percent of deposits from 68.3 percent at year-end 2011.   Wholesale internet time deposits decreased $14.6 million to 3.6 percent of deposits from 7.2 percent at year-end 2011.

Core deposits, defined as retail and commercial demand, NOW, money market and savings accounts, which generally have lower interest costs and management believes are more stable, increased $12.2 million, or 5.7%, to $227.2 million at March 31, 2012  from $215.0 million at year-end 2010.

Because the Consent Order establishes specific capital amounts to be maintained by the Bank, the Bank may not be considered better than “adequately capitalized” for capital adequacy purposes, even if the Bank exceeds the levels of capital set forth in the Consent Order. Currently, the Bank exceeds the capital levels established by the FDIC and the IDFPR in the Consent Order.

As an adequately capitalized institution, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC.  Brokered deposits also include deposits with rates of interest that are more than 75 basis points above the rate applicable to the applicable market of the Bank as determined by the FDIC.  However, the Bank has received designation by the FDIC that the Bank is operating in a high rate area.  This allows the Bank to use local average deposit rates as a basis for setting competitive rates on its deposits.  The Bank also has received permission from the FDIC to offer brokered CDARS time deposits.  At March 31, 2012, brokered CDARS time deposits totaled $10.2 million.

 Securities sold under repurchase agreements declined $2.8 million at March 31, 2012 to $16.6 million compared with $19.4 million at December 31, 2011.  The Company, by managing its liquidity, has lessened its reliance on this source of funds due to the pledging of securities that is required.  There were no related party repurchase agreements at March 31, 2012 and December 31, 2011.

36

NORTHERN STATES FINANCIAL CORPORATION

The Company is committed to actively service and maintain its current loan portfolio and is focused on the reduction of its nonperforming assets. As a consequence, the Company expects further declines in loan balances in 2012 due to scheduled principal payments and maturities.

The Company expects deposits to decrease by further reducing its reliance on wholesale internet time deposits that totaled $13.9 million at March 31, 2012.  Subsequent to March 31, 2012, the Company, in order to improve its net interest margin, reduced its deposit rates which the Company expects may cause deposit levels to decrease further.  With deposits expected to decrease, the Company will remain diligent in maintaining proper liquidity levels.

CAPITAL RESOURCES

Total stockholders’ equity decreased $2.9 million to $25.6 million at March 31, 2012 as compared with $28.5 million at year-end 2011.  The Company’s net loss of $2.8 million and accrual for dividends on the preferred stock of $243,000 for the three months ended March 31, 2012 were offset by a $86,000 increase to accumulated other comprehensive income relating to the unrealized gains on securities available for sale, net of deferred tax, and $30,000 due to the accretion of the unearned portion of stock awards.  The book value of the Company’s outstanding common stock at March 31, 2012 was $1.95 per share, compared with $2.65 at December 31, 2011.

On a consolidated basis, the Company’s Tier 1 to average assets ratio and total capital to assets ratio, on a risk adjusted basis, were 7.27 percent and 12.38 percent, respectively, at March 31, 2012.  The Bank’s Tier 1 to average assets ratio and the total capital to assets ratio, on a risk adjusted basis, were 8.23 percent and 13.30 percent, respectively, as of March 31, 2012, which are above the capital levels required by the Consent Order of 8.00 percent and 12.00 percent.

In January 2011, 207,500 shares of restricted stock were issued pursuant to the 2009 Restricted Stock Plan from the Company’s treasury stock.  During the second and third quarters of 2011, employees, who left the Company, forfeited 2,000 shares of restricted stock, which were returned to treasury stock. At March 31, 2012, 194,500 shares were available for issuance under the Plan.  Of the 80,000 shares issued to directors, 70,000 shares vested during the first quarter of 2011, while the remaining 10,000 shares fully vest in January 2013.  A total of 125,500 restricted stock shares granted to employees of the Company will fully vest in January 2013.  The expense attributable to these restricted stock awards recognized during the three months ended March 31, 2012 and 2011 totaled $30,000 and $152,000, respectively.

LIQUIDITY

The Company’s liquidity is measured by the ability to raise funds through deposits, borrowed funds, capital or cash flow from the repayment or maturities of loans and securities and net profits.   Liquidity is primarily managed through deposits and liquid assets such as cash and due from banks less any reserve requirements, securities available for sale less any pledged securities and federal funds sold.  Asset and liability management is the process of managing the balance sheet to achieve a mix of earning assets and liabilities in such a way that achieves an interest rate risk profile acceptable to management and assists in achieving a desired level of profitability.  An important part of the overall asset and liability management process is providing adequate liquidity.  The Company’s liquid assets consisting of cash and cash equivalents less any Federal Reserve Bank deposit requirements and normal branch cash reserves plus unpledged securities available for sale totaled $63.6 million at March 31, 2012, increasing $2.4 million as compared with $61.2 million at December 31, 2011.

37

NORTHERN STATES FINANCIAL CORPORATION

As required by the Consent Order, management developed a liquidity plan that identifies the sources of liquid assets available to meet the Bank’s contingency funding needs over the next twelve months.  This liquidity plan looks at the Bank’s ability to meet the cash flow requirements of customers and other operating needs and seeks to manage liquidity to meet these requirements.  The Company needs to have sufficient cash flow to meet borrowers’ needs to fund loans or the requirements of depositors wanting to withdraw funds.  The Statements of Cash Flows shows that for the three months ended March 31, 2012, cash and cash equivalents decreased by $466,000 to $37.4 million as compared with $37.8 million at December 31, 2011.

As part of the liquidity policy, management reviews the Bank’s on-balance sheet liquidity ratio daily.  The on-balance sheet liquidity ratio is the net liquid assets divided by total deposits.  At March 31, 2012, this internally calculated ratio at the Bank was 18.5 percent as compared with 18.2 percent at year-end 2011.

The Bank’s liquidity plan considers the liquidity provided by scheduled principal payments by borrowers and estimated principal reductions on mortgage-backed securities. The Bank expects to receive liquidity from loan principal payments by borrowers of approximately $530,000 per month and scheduled principal reductions on mortgage-backed securities of approximately $750,000 per month.

Federal funds sold and interest bearing deposits in financial institutions with maturities less than 90 days are a component of the Company’s cash and cash equivalents.  These funds totaled $29.9 million at March 31, 2012 as compared with $32.5 million at December 31, 2011.

The Company classifies all of its securities as available for sale, which increases the Company's flexibility in that the Company can use unpledged securities to meet liquidity requirements by selling the unpledged securities or by increasing its repurchase agreement balances.  Securities available for sale totaled $85.2 million at March 31, 2012, of which $51.2 million were pledged to secure public deposits and repurchase agreements.  At December 31, 2011, securities available for sale totaled $87.1 million of which $57.0 million were pledged.

Another source of liquidity to the Company is deposits. Under the Consent Order, the Bank must limit its brokered time deposits. As a result of the Consent Order, the Bank is not permitted to pay a rate of interest on deposit products that is more than 75 basis points above the rate applicable to the applicable market of the Bank as determined by the FDIC.  At March 31, 2012, wholesale internet time deposits and brokered time deposits decreased $16.2 million from year-end 2011 and the Company expects that they will continue to decrease due in part to the Bank’s compliance with the Consent Order.  The FDIC has recognized that the Bank is operating in a high rate area, which allows the Bank to use local average deposit rates as a basis for setting competitive rates on its deposits.  However, it is expected that deposits will continue to decline during the balance of 2012 and liquidity available from deposits will be limited.

An additional source of liquidity is a line of credit available at the Federal Home Loan Bank of Chicago, which was $14.3 million at March 31, 2012.  There were no outstanding balances on this line of credit at either March 31, 2012 or December 31, 2011.  At March 31, 2012, the Company has pledged loans totaling $26.1 million as security for this line.

The Consent Order also restricts payments of dividends from the Bank to the Company and as such conserves liquidity and capital at the Bank.  Dividends from the Bank are needed to fund dividend payments by the Company to its preferred and common stockholders and the interest payments on its subordinated debentures.   The Written Agreement between the Company and the Federal Reserve Bank dated March 17, 2011, prohibits the Company form paying dividends on its Series A Preferred Stock issued under the TARP Capital Purchase Program.  Due to these constraints, it is expected that the Company will continue to suspend dividend payments on its Series A Preferred Stock and will not pay any dividends to common stockholders in 2012.  Also, the Company will continue to defer interest payments on its subordinated debentures.  At March 31, 2012, the accumulated dividends payable on the Series A Preferred Stock totaled $2.4 million and the cumulative deferred interest payments payable on the subordinated debentures totaled $808,000.

38

NORTHERN STATES FINANCIAL CORPORATION

RESULTS OF OPERATIONS

NET INCOME

The Company recognized a loss available to common stockholders for the quarter ended March 31, 2012 of $3.1 million, as compared with a loss of $1.4 million for the same quarter of 2011.  The loss during the first quarter of 2012 was primarily due to a provision to the allowance for loan and lease losses of $1.4 million, write-downs to other real estate owned of $2.0 million and losses on the sale of other real estate owned of $216,000.  The loss for the same quarter of 2011 was primarily the result of provision to the allowance for loan and lease losses of $1.2 million, write-downs to other real estate owned of $673,000 and impairment write-downs to securities of $163,000.

NET INTEREST INCOME

Net interest income, the difference between interest income on earning assets and interest expense on interest bearing liabilities, decreased 7.8 percent or $364,000, and totaled $4.3 million for the quarter ended March 31, 2012  as compared with $4.6 million for the same quarter of 2011.  The decrease to net interest income for the quarter was attributable to a decrease in average interest earning assets of $70.9 million for the first quarter of 2012 as compared with the same quarter of 2011.

Most of the $70.9 million decline to average interest earning assets was attributable to decreases in average loans of $59.9 million and decreases in average federal funds sold and other interest earning assets of $6.2 million. The decrease in average loans was due to transfers of loans to other real estate owned, scheduled loan payments and payoffs and charge-offs of uncollectible loans to the ALLL. Average time deposits decreased $77.6 million during the quarter.

The net interest spread, the difference between rates earned on interest earning assets and paid on deposits and borrowings for the quarter ended March 31, 2012 increased 32 basis points to 3.91 percent as compared with 3.59 percent for the same quarter last year.  Yields on interest earning assets remained constant at 4.33 percent for the first quarter of 2012 as compared with the same quarter last year while rates paid on interest bearing liabilities declined 32 basis points.  The decline in rates paid on interest bearing liabilities was mainly due to rates paid on time deposit rates that decreased 56 basis points.

39

NORTHERN STATES FINANCIAL CORPORTION

TABLE 1

NORTHERN STATES FINANCIAL CORPORATION

ANALYSIS OF AVERAGE BALANCE AND TAX EQUIVALENT RATES

For the Three Months Ended  March 31, 2012 and 2011 - Rates are Annualized

($ 000s)

			2012							2011
	Average							Average
	Balance		Interest		Rate			Balance		Interest		Rate
Assets
Loans (1)(2)(3)	$	320,451	$	4,124		5.15	%	$	380,376	$	4,862		5.11	%
Taxable securities (4)		84,916		506		2.44	%		88,850		562		2.46	%
Tax advantaged securities (2)(4)		3,008		46		6.36	%		3,906		55		5.75	%
Federal funds sold and other interest earning assets		26,340		14		0.21	%		32,492		16		0.20	%
Interest earning assets (4)		434,715		4,690		4.33	%		505,624		5,495		4.33	%
Noninterest earning assets		19,782							28,053
Total average assets	$	454,497						$	533,677
Liabilities and stockholders' equity
NOW deposits	$	60,196	$	39		0.26	%	$	59,711	$	34		0.23	%
Money market deposits		53,384		40		0.30	%		51,066		44		0.34	%
Savings deposits		68,932		8		0.05	%		64,601		13		0.08	%
Time deposits		139,418		204		0.59	%		217,019		623		1.15	%
Other borrowings		27,887		73		1.05	%		38,770		87		0.90	%
Interest bearing liabilities		349,817		364		0.42	%		431,167		801		0.74	%
Demand deposits		68,184							62,316
Other noninterest bearing liabilities		7,762							6,398
Stockholders' equity		28,734							33,796
Total average liabilities and stockholders' equity	$	454,497						$	533,677
Net interest income			$	4,326						$	4,694
Net interest spread						3.91	%						3.59	%
Net yield on interest earning assets (4)						4.00	%						3.70	%
Interest-bearing liabilities to earning assets ratio						80.47	%						85.27	%

(1) - Interest income on loans includes loan origination and net fees of $19,000 and $28,000 for the three months ended March 31, 2012 and 2011, respectively.

(2) - Tax-exempt income is reflected on a fully tax equivalent basis utilizing a 34 percent tax rate. The tax equivalent adjustment reflected in the above table for municipal loans is approximately $26,000 and $27,000 for the three months ended March 31, 2012 and 2011, respectively.  The tax equivalent adjustment reflected in the above table for municipal securities is approximately $16,000 and $19,000 for the three months ended March 31, 2012 and 2011, respectively.

(3) - Non-accrual loans are included in average loans.

(4) - Rate information was calculated on the average amortized cost for securities.  The three months ended March 31, 2012 and 2011 average balance information includes an average unrealized gain (loss) for taxable securities of $1,797,000 and ($2,587,000) and for tax-advantaged securities of $114,000 and $81,000, respectively.

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NORTHERN STATES FINANCIAL CORPORTION

ASSET QUALITY AND THE PROVISION FOR LOAN AND LEASE LOSSES

At March 31, 2012, management, with the concurrence of the Board of Directors, after carefully reviewing the adequacy of the allowance for loan and lease losses and the levels of nonperforming and impaired loans and leases, determined that an allowance of $19.0 million, approximately the same level as at year-end 2011, was adequate to cover potential loan and lease losses,.  The Company’s allowance for loan and lease losses to total loans ratio was 6.01 percent at March 31, 2012 compared with 5.88 percent at December 31, 2011.

During the quarter ended March 31, 2012, $1.4 million in loans and leases were charged-off against the allowance due primarily to the charge-off of a $1.2 million construction loan as compared with charge-offs of $1.0 million during the same quarter last year.  Recoveries of loans previously charged-off totaled $1,000, as compared with $5,000 in recoveries during the same quarter in 2011.  The provision for loan and lease losses was $1.4 million as compared with $1.2 million during the same quarter in 2011.

Nonperforming loans and leases includes 1) loans and leases on nonaccrual status; 2) loans and leases 90 days or more past due and still accruing interest; and 3) accruing loans less than 90 days past due classified as troubled debt restructurings (“TDRs).  Total nonperforming loans and leases increased $7.6 million to $79.3 million, or 25.0 percent of total loans and leases, at March 31, 2012 as compared with $71.7 million, or 22.2 percent of total loans and leases, at December 31, 2011.

The $7.6 million increase to nonperforming loans from year-end 2011 was primarily the result of a $7.2 million increase to nonperforming real estate-construction loans that were affected by the continued decline in general real estate prices. During the first quarter of 2012, one real estate-construction loan relationship totaling $4.2 million secured by the construction of 1-4 family units became 90 days or more past due, still accruing while another real estate-construction  loan relationship secured by vacant loan totaling $4.0 million was classified as aTDR during the quarter as concessions were made to the borrower.

Nonaccrual loans decreased $736,000 to $18.7 million at March 31, 2012 from year-end 2011. The Company is attempting to work with the nonaccrual borrowers to resolve their issues, but in many cases where the loans are collateralized by real estate, the Company may have to foreclose on the properties securing the loans and transfer the collateral to other real estate owned.

Loans 90 days or more past due, still accruing totaled $5.8 million at March 31, 2012, an increase of $5.3 million from year-end 2011 primarily due to the addition during the quarter of one real estate-construction loan relationship totaling $4.2 million. These loans were considered both well secured and in the process of collection.

TDRs increased $3.0 million to $54.7 million at March 31, 2012 from year-end 2011 primarily due to a real estate-construction loan relationship totaling $4.0 million which was classified as aTDR during the first quarter of 2012.  Restructuring of loans is undertaken to improve the likelihood that the loan will be repaid in full under the modified terms in accordance with a reasonable repayment schedule. All restructured loans are evaluated to determine whether the loans should be reported as a TDR. A loan is a TDR when the Company, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower by modifying or renewing a loan that the Company would not otherwise consider. To make this determination the Bank must determine whether (a) the borrower is experiencing financial difficulties and (b) the Company granted the borrower a concession (c) absent the current modification, would the borrower more than likely default.  Factors to consider in determining whether the Company has granted a concession include: lowering the interest rate, extending the maturity date, forgiving debt, reducing accrued interest or changing the payment to interest only for an extended period of time. This determination requires consideration of all of the facts and circumstances surrounding the modification. An overall general decline in the economy or some deterioration in a borrower’s financial condition does not automatically mean the borrower is experiencing financial difficulties. TDRs at March 31, 2012 were still accruing and none were considered past due greater than 30 days.

41

NORTHERN STATES FINANCIAL CORPORTION

The Company considers a loan impaired if full principal and interest is not expected to be collected under the contractual terms of the original note.  Nonaccrual and accruing TDR loans are classified as impaired.  Impaired loans at March 31, 2012 totaled $77.7 million, as compared with $71.2 million at December 31, 2011, an increase of $6.5 million. Each impaired loan is individually evaluated for impairment and is carried at the lower of the loan balance or the present value of expected cash flows discounted at the loan's effective interest rate or at the fair value of the collateral less estimated costs to sell if the loan or lease is collateral dependent.  At March 31, 2012, $11.7 million of the allowance for loan and lease losses was allocated to impaired loans.

Management continues to emphasize the early identification of loan-related problems and remains aggressive in pursuing resolution strategies.  The Company has adopted a more stringent and disciplined loan underwriting policy in regards to relationship size and out of market credits.  The Company continues to be an active lender for its current customers as well as other qualifying prospective loan customers.

Another component of nonperforming assets is other real estate owned, consisting of assets acquired through or in lieu of foreclosure.  At March 31, 2012, other real estate owned totaled $17.9 million, a decrease of $1.4 million from $19.3 million at December 31, 2011.  The decrease in other real estate owned was due to sales of properties carried at $1.0 million in which the Company recognized  losses of $216,000 and write-downs of $2.0 million taken during the three months ended March 31, 2012. During the three months ended March 31, 2012, additions of $1.5 were made to other real estate owned from nonperforming loans.

The Company’s other real estate owned portfolio at March 31, 2012, consisted primarily of 5 plus family buildings and commercial real estate of $4.4 million and $8.8 million, respectively.  Other real estate owned also included $2.3 million of vacant land and $2.4 of single family homes. The Company is actively marketing all of its other real estate owned properties for sale.

The fair value of other real estate owned is reviewed by management at least quarterly to help ensure the reasonableness of its carrying value, which is lower of cost or the fair value less estimated selling costs.    If values continue to deteriorate, the Company may have future additional write-downs to its other real estate owned portfolio.

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NORTHERN STATES FINANCIAL CORPORTION

TABLE 2

NORTHERN STATES FINANCIAL CORPORATION

NONPERFORMING LOANS

($ 000s)

					Troubled Debt
			90 Days or		Restructured		Total Non-		% Non-
Nonperforming loans	Nonaccrual		More Past Due,		Loans,		performing		performing
at March 31, 2012	Loans		Still Accruing		Still Accruing		Loans		Loans
Commercial	$	542	$	0	$	106	$	648		0.8	%
Real estate-construction		3,607		4,230		6,425		14,262		18.0	%
Real estate-mortgage
1-4 family		954		474		3,310		4,738		6.0	%
Real estate-mortgage
5+ family		3,983		0		0		3,983		5.0	%
Real estate-mortgage commercial		8,875		1,107		44,890		54,872		69.2	%
Home equity		763		0		0		763		1.0	%
Leases		0		0		0		0		0.0	%
Installment		0		15		0		15		0.0	%
Total	$	18,724	$	5,826	$	54,731	$	79,281		100.0	%

					Troubled Debt
			90 Days or		Restructured		Total Non-		% Non-
Nonperforming loans	Nonaccrual		More Past Due,		Loans,		performing		performing
at December 31, 2011	Loans		Still Accruing		Still Accruing		Loans		Loans
Commercial	$	548	$	0	$	108	$	656		0.9	%
Real estate-construction		4,447		152		2,428		7,027		9.8	%
Real estate-mortgage
1-4 family		1,263		0		3,901		5,164		7.2	%
Real estate-mortgage
5+ family		3,987		0		0		3,987		5.6	%
Real estate-mortgage commercial		8,772		0		45,301		54,073		75.4	%
Home equity		443		322		0		765		1.1	%
Leases		0		0		0		0		0.0	%
Installment		0		16		0		16		0.0	%
Total	$	19,460	$	490	$	51,738	$	71,688		100.0	%

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NORTHERN STATES FINANCIAL CORPORTION

TABLE 3

NORTHERN STATES FINANCIAL CORPORATION

OTHER REAL ESTATE OWNED

($ 000's)

	March 31,		December 31,
	2012		2011
Real estate - vacant land	$	2,266	$	2,212
Real estate - 1-4 family		2,416		1,834
Real estate - 5+ family		4,433		6,565
Real estate - commercial		8,744		8,731
Total other real estate owned	$	17,859	$	19,342

	Three months ended
	March 31,			March 31,
	2012			2011
Balance beginning of the period	$	19,342		$	24,326
Additions		1,453			61
Improvements		0			0
Sales proceeds		(748	)		(1,544	)
Gains (losses) on sales		(216	)		67
Write-downs		(1,972	)		(673	)
Balance at end of period	$	17,859		$	22,237

NONINTEREST INCOME

 Noninterest income for the three months ended March 31, 2012 was $651,000 as compared to $833,000 for the three months ended March 31, 2011, a decrease of $182,000.  Noninterest income declined as the Company recognized losses of $216,000 from the sale of $1.0 million of other real estate owned as compared to gains of $67,000 on the sale of $1.5 million in the same three months of 2011.  Contributing to the decrease in noninterest income were declines in service fees on deposits of $30,000 and trust income of $45,000.  During March 2012, the Company instituted increased service charges on deposit accounts and anticipates increases to service fees in following periods.  Partially offsetting these decreases was that there was no impairment write-downs of securities during the three months ended March 31, 2012 as compared with $163,000 for the same three months of 2011.

NONINTEREST EXPENSE

Noninterest expense for the quarter ended March 31, 2012 was $6.4 million, increasing $1.0 million from the same quarter last year.  Noninterest expense increased $1.3 million due to write-downs to other real estate owned of $2.0 million compared with $673,000 for the same quarter of 2011.  Data processing expense also increased $65,000.  The Company made a change to its item processing system during the first quarter of 2012 and expects lower data processing expense in following periods. Partially offsetting these increases were declines to FDIC insurance premiums, other real estate owned expenses and occupancy and equipment expenses.  FDIC insurance expense declined $125,000 due to changes to the FDIC assessment base.  Other real estate owned expenses declined $107,000 as the Company has rented some of its other real estate owned properties and rental income offset expenses.   Occupancy and equipment expense declined $73,000 in part due to lower utility and maintenance expenses partially attributable to the mild winter.

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NORTHERN STATES FINANCIAL CORPORTION

FEDERAL AND STATE INCOME TAXES

The Company recognized no income tax benefit for the three months ended March 31, 2012 and 2011 despite having an operating loss before income taxes of $2.8 million and $1.1 million, respectively.  Per accounting rules, the Company continued to book tax benefits adjusted for timing differences as a deferred tax asset with a corresponding offset to the deferred tax asset valuation allowance, without recognizing a tax benefit on the income statement due to uncertainties as to the realization of these benefits.  For the three months ended March 31, 2012, the Company’s tax benefit was calculated to be $1.1 million and the deferred taxes increased to $21.6 million exclusive of the deferred tax effect of the unrealized gains of the Company’s securities.  The Company will continue to analyze its deferred tax assets quarterly.

REGULATORY MATTERS

On March 17, 2011, the Company and the Federal Reserve Bank entered into a Written Agreement. Pursuant to the Written Agreement, among other things, the Company has agreed to: (i) serve as a source of strength to the Bank; (ii) abstain from paying any dividends, redeeming any stock or incurring any debt without Federal Reserve approval; (iii) adopt a capital plan; (iv) provide the Federal Reserve with cash flow projections on a quarterly basis; (v) notify the Federal Reserve of the proposed addition of any individual to the Board of Directors or the employment of any individual as a senior executive officer of the Company before such addition or employment becomes effective; and (vi) provide progress reports to the Federal Reserve concerning the Company’s compliance with the Written Agreement.

Prior to the Written Agreement, the Company adopted a Board Resolution dated November 17, 2009 which the Written Agreement superseded. The Board Resolution required that the Company obtain written approval from the Federal Reserve prior to: (i) paying dividends to common or preferred stockholders (ii) increasing holding company level debt or subordinated debentures issued in conjunction with trust preferred securities obligations (iii) paying interest on subordinated debentures or (iv) repurchasing Company stock.

In November 2009, in response to the Board Resolution, the Company notified the U.S. Treasury Department (“Treasury”) of its intent to suspend its dividend payments on its Fixed Rate Cumulative Perpetual Preferred Stock, Series A (“Series A Preferred Stock”). The suspension of the dividend payments is permissible under the terms of the Troubled Asset Relief Program Capital Purchase Program, but the dividend is a cumulative dividend and failure to pay dividends for six dividend periods triggers board of director appointment rights for the holder of the Series A Preferred Stock. At March 31, 2012, the Company had suspended ten dividend payments and has a payable of $2,398,000 for the preferred stock dividends. The Company expects that the Treasury Department will appoint two directors to its board in 2012.  In January 2011, the Company agreed to allow a Treasury Department observer to attend its board of directors meetings. While dividends are being deferred on the preferred stock issued under the TARP CPP, the Company may not pay dividends on its common stock.

In November 2009, the Company notified the trustee that holds the Company’s junior subordinated debentures relating to its trust preferred securities that the Company would be deferring its regularly scheduled quarterly interest payments. The Company has the right to defer the payment of interest on the junior subordinated debentures at any time, for a period not to exceed 20 consecutive quarters. At March 31, 2012, the Company had deferred payment of ten regularly scheduled quarterly interest payments and has a payable of $808,000 for the interest on the subordinated debentures. During the deferral period, the Company may not pay any dividends on its common or preferred stock.

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NORTHERN STATES FINANCIAL CORPORTION

On April 16, 2010 the NorStates Bank ("Bank") and the FDIC and the IDFPR entered into a joint Consent Order. The Consent Order requires, among other things, increased Bank Board of Directors oversight, certain minimum capital levels, action plans to reduce and manage its classified assets and no payments of dividends without prior approval from its regulators (see Note 9).

The Consent Order requires the Bank to maintain Tier 1 capital to average assets at a minimum of 8.00% and total capital to risk weighted assets at a minimum of 12.00%.  As noted above, the Bank's Tier 1 capital to average assets was 8.23% and total capital to risk weighted assets was 13.30% as of March 31, 2012. Under the Consent Order the Bank may not be considered "well capitalized" for capital adequacy purposes even if it exceeds the levels of capital set forth in the Consent Order.  As of March 31, 2012, the Bank was considered "adequately capitalized".

For additional information on regulatory matters, see Note 8 and Note 9 in this document in the notes to the interim condensed consolidated financial statements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

The Company’s primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. Interest rate risk is the exposure of a banking organization’s financial condition to adverse movements in interest rates.  The Company seeks to achieve consistent growth in net interest income and net income while managing volatility that arises from shifts in interest rates.  The Company’s Asset and Liability Management Committee (“ALCO”) oversees interest rate risk programs instituted by management and measurements of interest rate risk verifying that they are within authorized limits set by the Company’s Board of Directors.

Evaluating a financial institution’s exposure to changes in interest rates includes assessing both the adequacy of the management process used to control interest rate risk and the organization’s quantitative level of exposure.  When assessing the interest rate risk management process, the Company seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain interest rate risk at prudent levels.  Evaluating the quantitative level of interest rate risk exposure requires the Company to assess the existing and potential future effects of changes in interest rates on its consolidated financial condition, including capital adequacy, earnings, and liquidity.

Proper interest rate risk evaluation must include active board of director and senior management oversight and a comprehensive risk-management process that effectively identifies, measures, and controls interest rate risk.  Several techniques might be used by an institution to minimize interest rate risk.  Such activities fall under the broad definition of asset/liability management.

One approach used by the Company is to periodically analyze the matching of assets and liabilities by examining the extent to which such assets and liabilities are "interest rate sensitive" and by monitoring the Bank's interest rate sensitivity "gap".

An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or reprice within that time period.  The interest rate sensitivity gap is defined as the difference between the amount of interest earning assets maturing or repricing within a specific time period and the amount of interest bearing liabilities maturing or repricing within that same time period.  A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities and a gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets in a given time frame.  During a period of rising interest rates, a negative gap would tend to adversely affect net interest income while a positive gap would tend to result in an increase in net interest income.

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NORTHERN STATES FINANCIAL CORPORTION

Another approach used by management to analyze interest rate risk is to periodically evaluate or “shock” the Company’s base 12- month projected net interest income by assuming an instantaneous decrease or increase in rates using computer simulation.  Table 5 shows this analysis at March 31, 2012 and December 31, 2011.  The computer simulation model used to do the interest rate shocks and calculate the effect on projected net interest income takes into consideration maturity and repricing schedules of the various assets and liabilities as well as call provisions on the Company’s securities.  Current policy set by the Board of Directors limits exposure to net interest income from interest rate shocks.

TABLE 4

NORTHERN STATES FINANCIAL CORPORATION

EFFECT OF INTEREST SHOCKS ON NET INTEREST INCOME

as of March 31, 2012 and December 31, 2011

($000s)

				Immediate Change in Rates
		-2.00%			-1.00%			+1.00%			+2.00%	%
March 31, 2012:
Dollar Change from Base Forecast	$	(349	)	$	(59	)	$	225		$	493
Percent Change from Base Forecast	-2.01%			-0.34%			1.29%			2.84%
December 31, 2011:
Dollar Change from Base Forecast	$	(12	)	$	298		$	53		$	122
Percent Change from Base Forecast		-0.07	%		1.74	%		0.31	%		0.71	%

At April 25, 2012, the base forecasted 12-month net interest income increases $493,000 when rates are shocked upwards 2% while net interest income decreases $349,000 for a 2% downwards rate shock.

The Company can manage interest rate risk by selling existing assets, repaying certain liabilities or matching repricing periods for new assets and liabilities.  Financial institutions are subject to prepayment risk in a falling rate environment.  For example, a debtor may prepay financial assets in order to refinance obligations at new, lower rates.  The Company attempts to mitigate this risk by having prepayment penalties on fixed rate loans.  The Company also seeks to mitigate the effect on net interest income from variable rate loans by placing floors whenever possible.  In a rising rate environment financial institutions are subject to early redemption of time deposits.  The Company attempts to mitigate this risk by having prepayment penalties on early redemptions.

Based on the April 25, 2012 monetary policy announcement of the Federal Reserve’s Federal Open Market Committee, it is anticipated that rates will remain at historic lows until late 2014.

ITEM 4. CONTROLS AND PROCEDURES.

The Company’s management has evaluated, with the participation of the President and Chief Executive Officer, and Vice President and Chief Financial Officer, the Company’s disclosure controls and procedures (as such term is defined in Rule 13a – 15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report.  Based on that evaluation, the President and Chief Executive Officer, and Vice President and Chief Financial Officer, have concluded that these controls and procedures were effective, in all material respects, as of such date.  There were no changes in the Company’s internal control over financial reporting (as such term is defined in Rule 13a – 15(f) under the Securities Exchange Act of 1934) that occurred during the first quarter of 2012 that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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NORTHERN STATES FINANCIAL CORPORTION

PART II. OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS.

From time to time, due to the nature of its business, the Company and its subsidiaries are often subject to various legal actions.  These legal actions, whether pending or threatened, arise through the normal course of business and neither the Company nor any of its subsidiaries are currently involved in any proceedings that would, in management’s judgment, have a material adverse effect on the Company’s business, results of operations, financial condition or cash flows.

ITEM 1A.  RISK FACTORS.

There have been no material changes to the risk factors relating to the Company from those risk factors previously disclosed in the Company’s Annual Report on Form 10-K for its fiscal year ended December 31, 2011 in response to Item 1A. to Part I of Form 10-K.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

None.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES.

None.

ITEM 4.  MINE SAFETY DISCLOSURES.

None.

ITEM 5.  OTHER INFORMATION.

None.

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ITEM 6.  EXHIBITS.

(a) Exhibits.

Exhibit 3.1- Certificate of Incorporation of the Company, as amended (incorporated herein by reference to the Company’s Annual Report on Form 10-K for the year ended December 31, 1994 (File No. 000-19300)).

Exhibit 3.2 - Certificate of Amendment of the Certificate of Incorporation of the Company, as amended, dated April 27, 1998 (incorporated herein by reference to Exhibit 3.2 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2008 (File No. 000-19300) filed on March 25, 2009).

Exhibit 3.3 - Certificate of Amendment of the Certificate of Incorporation of the Company, as amended, dated January 20, 2009 (incorporated herein by reference to Exhibit 3.3 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2008 (File No. 000-19300) filed on March 25, 2009).

Exhibit 3.4 - Certificate of Designations of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, dated February 18, 2009 (incorporated herein by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K (File No. 000-19300) filed on February 20, 2009).

Exhibit 3.5 - Amended and Restated By-laws of the Company dated April 20, 2004 (incorporated herein by reference to Exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q (File No. 000-19300) filed on May 10, 2004).

Exhibit 4.1 - Form of Certificate of the Preferred Stock (incorporated herein by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K (File No. 000-19300) filed on February 20, 2009).

Exhibit 4.2 - Warrant to purchase shares of Common Stock (incorporated herein by reference to Exhibit 4.2 to the Company’s Current Report on Form 8-K (File No. 000-19300) filed on February 20, 2009).

Exhibit 11.1 - Statement of Computation of per share earnings. (Contained in Notes 1 and 3 to the condensed consolidated financial statements.)

Exhibit 15.1 - Acknowledgement of Independent Registered Public Accounting Firm.

Exhibit 31.1 - Section 302 Certification of President and Chief Executive Officer.

Exhibit 31.2 - Section 302 Certification of Vice President and Chief Financial Officer.

Exhibit 32.1 - Section 906 Certification.

Exhibit 101.1 - The following financial statements from the Northern States Financial Corporation Quarterly Report on Form 10-Q for the quarter ended March 31, 2012, formatted in Extensive Business Reporting Language (XBRL): (i) condensed consolidated balance sheets, (ii) condensed consolidated statements of operations, (iii) condensed consolidated statements of cash flows, (iv) condensed consolidated statements of stockholders’ equity, and (v) the notes to condensed consolidated financial statements.*

*Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files submitted under Exhibit 101.1 are not deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, or otherwise subject to the liability of that Section.  Such exhibit shall not be deemed incorporated into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934.

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NORTHERN STATES FINANCIAL CORPORATION

FORM 10-Q

March 31, 2012

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report on Form 10-Q to be signed on its behalf by the undersigned thereunto duly authorized.

NORTHERN STATES FINANCIAL CORPORATION

(Registrant)

Date	May 1, 2012	By:	/s/ Scott Yelvington
			Scott Yelvington
			President and Chief Executive Officer

Date	May 1, 2012	By:	/s/ Steven Neudecker
			Steven Neudecker
			Vice President and Chief Financial Officer

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NORTHERN STATES FINANCIAL CORPORATION

FORM 10-Q

March 31, 2012

EXHIBIT INDEX

Exhibits

Exhibit 3.1 - Certificate of Incorporation of the Company, as amended (incorporated herein by reference to the Company’s Annual Report on Form 10-K for the year ended December 31, 1994 (File No. 000-19300)).

Exhibit 3.2 - Certificate of Amendment of the Certificate of Incorporation of the Company, as amended dated April 27, 1998 (incorporated herein by reference to Exhibit 3.2 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2008 (File No. 000-19300) filed on March 25, 2009).

Exhibit 3.3 - Certificate of Amendment of the Certificate of Incorporation of the Company, as amended dated January 20, 2009 (incorporated herein by reference to Exhibit 3.3 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2008 (File No. 000-19300) filed on March 25, 2009).

Exhibit 3.4 - Certificate of Designations of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, dated February 18, 2009 (incorporated herein by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K (File No. 000-19300) filed on February 20, 2009).

Exhibit 3.5 - Amended and Restated By-laws of the Company dated April 20, 2004 (incorporated herein by reference to Exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q (File No. 000-19300) filed on May 10, 2004).

Exhibit 4.1 - Form of Certificate of the Preferred Stock (incorporated herein by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K (File No. 000-19300) filed on February 20, 2009).

Exhibit 4.2 - Warrant to purchase shares of Common Stock (incorporated herein by reference to Exhibit 4.2 to the Company’s Current Report on Form 8-K (File No. 000-19300) filed on February 20, 2009).

Exhibit 11.1 - Statement of Computation of per share earnings. (Contained in Notes 1 and 3 to the condensed consolidated financial statements.)

Exhibit 15.1 - Acknowledgement of Independent Registered Public Accounting Firm.

Exhibit 31.1 - Section 302 Certification of President and Chief Executive Officer.

Exhibit 31.2 - Section 302 Certification of Vice President and Chief Financial Officer.

Exhibit 32.1 - Section 906 Certification.

Exhibit 101.1 - The following financial statements from the Northern States Financial Corporation Quarterly Report on Form 10-Q for the quarter ended March 31, 2012, formatted in Extensive Business Reporting Language (XBRL): (i) condensed consolidated balance sheets, (ii) condensed consolidated statements of operations, (iii) condensed consolidated statements of cash flows, (iv) condensed consolidated statements of stockholders’ equity, and (v) the notes to condensed consolidated financial statements.*

*Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files submitted under Exhibit 101.1 are not deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, or otherwise subject to the liability of that Section.  Such exhibit shall not be deemed incorporated into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934.

51