3. Credit Quality of Loans and Allowance for Loan Losses

The loan portfolio consisted of the following (in thousands):

	June 30, 2014			December 31, 2013
Commercial, financial and agricultural	$	454,310		$	403,976
Real estate - construction		86,238			82,691
Real estate – commercial		413,565			397,135
Real estate – residential		153,082			146,841
Installment loans to individuals		108,581			97,459
Lease financing receivable		4,750			5,542
Other		3,656			3,910
		1,224,182			1,137,554
Less allowance for loan losses		(9,075	)		(8,779	)
	$	1,215,107		$	1,128,775

The Company monitors loan concentrations and evaluates individual customer and aggregate industry leverage, profitability, risk rating distributions, and liquidity for each major standard industry classification segment. At June 30, 2014, one industry segment concentration, the oil and gas industry, constituted more than 10% of the loan portfolio. The Company’s exposure in the oil and gas industry, including related service and manufacturing industries, totaled approximately $261.8 million, or 21.4% of total loans. Additionally, the Company’s exposure to loans secured by commercial real estate is monitored. At June 30, 2014, loans secured by commercial real estate (including commercial construction, farmland and multifamily loans) totaled approximately $476.3 million. Of the $476.3 million, $379.2 million represent CRE loans, 64% of which are secured by owner-occupied commercial properties. Of the $476.3 million in loans secured by commercial real estate, $3.4 million, or 0.7%, were on nonaccrual status at June 30, 2014.

Allowance for Loan Losses

The allowance for loan losses is a valuation account available to absorb probable losses on loans. All losses are charged to the allowance for loan losses when the loss actually occurs or when a determination is made that a loss is likely to occur. Recoveries are credited to the allowance for loan losses at the time of recovery. Quarterly, the probable level of losses in the existing portfolio is estimated through consideration of various factors. Based on these estimates, the allowance for loan losses is increased by charges to earnings and decreased by charge‑offs (net of recoveries).

The allowance is composed of general reserves and specific reserves. General reserves are determined by applying loss percentages to segments of the portfolio. The loss percentages are based on each segment’s historical loss experience, generally over the past twelve to eighteen months, and adjustment factors derived from conditions in the Company’s internal and external environment. All loans considered to be impaired are evaluated on an individual basis to determine specific reserve allocations in accordance with GAAP. Loans for which specific reserves are provided are excluded from the calculation of general reserves.

Loans acquired in business combinations are initially recorded at fair value, which includes an estimate of credit losses expected to be realized over the remaining lives of the loans, and therefore no corresponding allowance for loan losses is recorded for these loans at acquisition. Methods utilized to estimate any subsequently required allowance for loan losses for acquired loans not deemed credit-impaired at acquisition are similar to originated loans; however, the estimate of loss is based on the unpaid principal balance and then compared to any remaining unaccreted purchase discount. To the extent that the calculated loss is greater than the remaining unaccreted purchase discount, an allowance is recorded for such difference.

The Company has an internal loan review department that is independent of the lending function to challenge and corroborate the loan grade assigned by the lender and to provide additional analysis in determining the adequacy of the allowance for loan losses.

A rollforward of the activity within the allowance for loan losses by loan type and recorded investment in loans for the six months ended June 30, 2014 and 2013 is as follows (in thousands):

	June 30, 2014
				Real Estate
	Coml, Fin, and Agric			Construction			Commercial			Residential			Consumer			Finance Leases Coml			Other		Total
Allowance for loan losses:
Beginning balance	$	3,906		$	1,046		$	1,389		$	1,141		$	1,273		$	21		$	3	$	8,779
Charge-offs		(1,135	)		-			(17	)		(176	)		(350	)		-			-		(1,678	)
Recoveries		42			-			42			39			101			-			-		224
Provision		1,970			(53	)		(23	)		(325	)		184			(4	)		1		1,750
Ending balance	$	4,783		$	993		$	1,391		$	679		$	1,208		$	17		$	4	$	9,075
Ending balance: individually evaluated for impairment	$	208		$	3		$	55		$	152		$	145		$	-		$	-	$	563
Ending balance: collectively evaluated for impairment	$	4,575		$	990		$	1,336		$	527		$	1,063		$	17		$	4	$	8,512

Loans:
Ending balance	$	454,310		$	86,238		$	413,565		$	153,082		$	108,581		$	4,750		$	3,656	$	1,224,182
Ending balance: individually evaluated for impairment	$	1,793		$	152		$	3,234		$	1,214		$	340		$	-		$	-	$	6,733
Ending balance: collectively evaluated for impairment	$	452,517		$	86,086		$	409,631		$	151,763		$	108,241		$	4,750		$	3,656	$	1,216,644
Ending balance: loans acquired with deteriorated credit quality	$	-		$	-		$	700		$	105		$	-		$	-		$	-	$	805

				June 30, 2013
				Real Estate
	Coml, Fin, and Agric			Construction			Commercial			Residential			Consumer			Finance Leases Coml			Other		Total
Allowance for loan losses:
Beginning balance	$	1,535		$	2,147		$	2,166		$	936		$	543		$	41		$	2	$	7,370
Charge-offs		(245	)		-			(18	)		(115	)		(413	)		-			-		(791	)
Recoveries		39			5			15			26			67			-			-		152
Provision		2,364			(1,061	)		80			(328	)		760			(17	)		2		1,800
Ending balance	$	3,693		$	1,091		$	2,243		$	519		$	957		$	24		$	4	$	8,531
Ending balance: individually evaluated for impairment	$	328		$	54		$	21		$	68		$	128		$	-		$	-	$	599
Ending balance: collectively evaluated for impairment	$	3,365		$	1,037		$	2,222		$	451		$	829		$	24		$	4	$	7,932

Loans:
Ending balance	$	391,241		$	82,851		$	404,543		$	141,689		$	90,571		$	5,656		$	2,021	$	1,118,572
Ending balance: individually evaluated for impairment	$	1,648		$	262		$	2,556		$	1,024		$	315		$	-		$	-	$	5,805
Ending balance: collectively evaluated for impairment	$	389,593		$	82,589		$	401,277		$	140,375		$	90,256		$	5,656		$	2,021	$	1,111,767
Ending balance: loans acquired with deteriorated credit quality	$	-		$	-		$	710		$	290		$	-		$	-		$	-	$	1,000

Non-Accrual and Past Due Loans

Loans are considered past due if the required principal and interest payment have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management’s opinion, the probability of collection of interest is deemed insufficient to warrant further accrual. For loans placed on non-accrual status, the accrual of interest is discontinued and subsequent payments received are applied to the principal balance. Interest income is recorded after principal has been satisfied and as payments are received. Non-accrual loans may be returned to accrual status if all principal and interest amounts contractually owed are reasonably assured of repayment within a reasonable period and there is a period of at least six months to one year of repayment performance by the borrower depending on the contractual payment terms.

An age analysis of past due loans (including both accruing and non-accruing loans) is as follows (in thousands):

	June 30, 2014

	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current		Total Loans		Recorded Investment > 90 days and Accruing
Commercial, financial, and agricultural	$	1,846	$	790	$	1,591	$	4,227	$	450,083	$	454,310	$	27
Commercial real estate - construction		58		-		73		131		62,626		62,757		-
Commercial real estate - other		1,658		378		2,902		4,938		408,627		413,565		159
Residential - construction		-		-		44		44		23,437		23,481		-
Residential - prime		763		33		905		1,701		151,381		153,082		-
Consumer - credit card		22		8		17		47		5,957		6,004		17
Consumer - other		514		321		333		1,168		101,409		102,577		-
Lease financing receivable		-		-		-		-		4,750		4,750		-
Other loans		118		5		-		123		3,533		3,656		-
	$	4,979	$	1,535	$	5,865	$	12,379	$	1,211,803	$	1,224,182	$	203

	December 31, 2013
	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current		Total Loans		Recorded Investment > 90 days and Accruing
Commercial, financial, and agricultural	$	4,350	$	208	$	1,256	$	5,814	$	398,162	$	403,976	$	26
Commercial real estate - construction		36		-		63		99		64,794		64,893		-
Commercial real estate - other		1,230		1,447		2,395		5,072		392,063		397,135		141
Residential - construction		149		-		-		149		17,649		17,798		-
Residential - prime		2,984		870		307		4,161		142,680		146,841		-
Consumer - credit card		36		-		7		43		6,163		6,206		7
Consumer - other		767		102		269		1,138		90,115		91,253		4
Lease financing receivable		-		-		-		-		5,542		5,542		-
Other loans		125		-		-		125		3,785		3,910		-
	$	9,677	$	2,627	$	4,297	$	16,601	$	1,120,953	$	1,137,554	$	178

Non-accrual loans are as follows (in thousands):

	June 30, 2014		December 31, 2013
Commercial, financial, and agricultural	$	1,779	$	1,272
Commercial real estate – construction		108		100
Commercial real estate - other		3,296		2,290
Residential - construction		44		-
Residential - prime		1,340		1,153
Consumer - credit card		-		-
Consumer - other		346		284
Lease financing receivable		-		-
Other		-		-
	$	6,913	$	5,099

The amount of interest that would have been recorded on non-accrual loans, had the loans not been classified as non-accrual, totaled approximately $275,000 and $281,000 for the six months ended June 30, 2014 and 2013, respectively. Interest actually received on non-accrual loans at June 30, 2014 and 2013 was $91,000 and $243,000, respectively.

Impaired Loans

Loans are considered impaired when, based upon current information, it is probable the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. All loans classified as special mention, substandard, or doubtful, based on credit risk rating factors, and are reviewed for impairment. An allowance for each impaired loan is calculated based on the present value of expected future cash flows discounted at the loan’s effective interest rate or at the loan’s observable market price or the fair value of the collateral if the loan is collaterally dependent. All impaired loans are reviewed, at a minimum, on a quarterly basis. Existing valuations are reviewed to determine if additional discounts or new appraisals are required. After this review, when comparing the resulting collateral valuation to the outstanding loan balance, if the discounted collateral value exceeds the loan balance no specific allocation is reserved. Acquired impaired loans are generally not subject to individual evaluation for impairment and are not reported with impaired loans or troubled debt restructurings, even if they would otherwise qualify for such treatment.

Loans that are individually evaluated for impairment are as follows (in thousands):

	June 30, 2014
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial, financial, and agricultural	$	508	$	901	$	-	$	1,175	$	-
Commercial real estate – construction		69		69		-		71		-
Commercial real estate – other		2,869		3,343		-		2,783		2
Residential – prime		469		469		-		499		1
Residential – construction		44		44		-		44		-
Consumer – other		64		64		-		62		-
Subtotal:		4,023		4,890		-		4,634		3
With an allowance recorded:
Commercial, financial, and agricultural		1,285		1,285		208		858		1
Commercial real estate – construction		39		39		3		39		1
Commercial real estate – other		365		365		55		431		-
Residential – prime		745		764		152		583		10
Consumer – other		276		291		145		254		1
Subtotal:		2,710		2,744		563		2,165		13
Totals:
Commercial		5,027		5,894		263		5,247		3
Residential		1,214		1,233		152		1,082		11
Construction		152		152		3		154		1
Consumer		340		355		145		316		1
Grand total:	$	6,733	$	7,634	$	563	$	6,799	$	16

	December 31, 2013
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial, financial, and agricultural	$	671	$	1,107	$	-	$	617	$	3
Commercial real estate – construction		61		61		-		416		-
Commercial real estate – other		1,850		2,324		-		2,190		8
Residential – prime		525		525		-		1,050		14
Consumer – other		66		66		-		90		1
Subtotal:		3,173		4,083		-		4,363		26
With an allowance recorded:
Commercial, financial, and agricultural		570		570		168		821		3
Commercial real estate – construction		39		39		3		102		1
Commercial real estate – other		363		363		54		372		11
Residential – prime		375		395		60		214		4
Consumer – other		205		205		120		211		2
Subtotal:		1,552		1,572		405		1,720		21
Totals:
Commercial		3,454		4,364		222		4,000		25
Residential		900		920		60		1,264		18
Construction		100		100		3		518		1
Consumer		271		271		120		301		3
Grand total:	$	4,725	$	5,655	$	405	$	6,083	$	47

Credit Quality

The Company manages credit risk by observing written underwriting standards and lending policy established by the Board of Directors and management to govern all lending activities. The risk management program requires that each individual loan officer review his or her portfolio on a quarterly basis and assign recommended credit ratings on each loan. These efforts are supplemented by independent reviews performed by a loan review officer and other validations performed by the internal audit department. The results of the reviews are reported directly to the Audit Committee of the Board of Directors.

Loans can be classified into the following three risk rating grades: pass, special mention, and substandard/doubtful. Factors considered in determining a risk rating grade include debt service capacity, capital structure/liquidity, management, collateral quality, industry risk, company trends/operating performance, repayment source, revenue diversification/customer concentration, quality of financial information, and financing alternatives. Pass grade signifies the highest quality of loans to loans with reasonable credit risk, which may include borrowers with marginally adequate financial performance, but have the ability to repay the debt. Special mention loans have potential weaknesses that warrant extra attention from the loan officer and other management personnel, but still have the ability to repay the debt. Substandard classification includes loans with well-defined weaknesses with risk of potential loss. Loans classified as doubtful are considered to have little recovery value and are charged off.

The following tables present the classes of loans by risk rating (in thousands):

	June 30, 2014
Commercial Credit Exposure
Credit Risk Profile by Creditworthiness Category
	Commercial, financial, and agricultural		Commercial real estate - construction		Commercial real estate - other		Total		% of Total
Pass	$	443,503	$	62,615	$	387,732	$	893,850		96.05	%
Special mention		6,303		34		8,269		14,606		1.57	%
Substandard		4,250		108		17,564		21,922		2.35	%
Doubtful		254		-		-		254		0.03	%
	$	454,310	$	62,757	$	413,565	$	930,632		100.00	%

Residential Credit Exposure
Credit Risk Profile by Creditworthiness Category
	Residential - construction		Residential - prime		Total		% of Total
Pass	$	23,437	$	148,562	$	171,999		97.42	%
Special mention		-		444		444		0.25	%
Substandard		44		4,076		4,120		2.33	%
	$	23,481	$	153,082	$	176,563		100.00	%

Consumer and Commercial Credit Exposure
Credit Risk Profile Based on Payment Activity
	Consumer - credit card		Consumer - other		Lease financing receivable		Other		Total		% of Total
Performing	$	5,995	$	102,178	$	4,750	$	3,656	$	116,579		99.65	%
Nonperforming		9		399		-		-		408		0.35	%
	$	6,004	$	102,577	$	4,750	$	3,656	$	116,987		100.00	%

	December 31, 2013
Commercial Credit Exposure
Credit Risk Profile by Creditworthiness Category
	Commercial, financial, and agricultural		Commercial real estate - construction		Commercial real estate - other		Total		% of Total
Pass	$	397,513	$	63,577	$	371,618	$	832,708		96.15	%
Special mention		2,962		49		8,781		11,792		1.36	%
Substandard		3,272		1,267		16,736		21,275		2.46	%
Doubtful		229		-		-		229		0.03	%
	$	403,976	$	64,893	$	397,135	$	866,004		100.00	%


Residential Credit Exposure
Credit Risk Profile by Creditworthiness Category
	Residential - construction		Residential - prime		Total		% of Total
Pass	$	17,798	$	143,790	$	161,588		98.15	%
Special mention		-		548		548		0.33	%
Substandard		-		2,503		2,503		1.52	%
	$	17,798	$	146,841	$	164,639		100.00	%

Consumer and Commercial Credit Exposure
Credit Risk Profile Based on Payment Activity
	Consumer - credit card		Consumer - other		Lease financing receivable		Other		Total		% of Total
Performing	$	6,196	$	90,978	$	5,542	$	3,910	$	106,626		99.73	%
Nonperforming		10		275		-		-		285		0.27	%
	$	6,206	$	91,253	$	5,542	$	3,910	$	106,911		100.00	%

Troubled Debt Restructurings

A troubled debt restructuring (“TDR”) is a restructuring of a debt made by the Company to a debtor for economic or legal reasons related to the debtor’s financial difficulties that it would not otherwise consider. The Company grants the concession in an attempt to protect as much of its investment as possible.

Information about the Company’s TDRs is as follows (in thousands):

	June 30, 2014
	Current		Past Due Greater Than 30 Days		Nonaccrual TDRs		Total TDRs
Commercial, financial and agricultural	$	23	$	-	$	234	$	257
Real estate - commercial		160		-		-		160
	$	183	$	-	$	234	$	417

	December 31, 2013
	Current		Past Due Greater Than 30 Days		Nonaccrual TDRs		Total TDRs
Commercial, financial and agricultural	$	-	$	23	$	233	$	256
Real estate - commercial		156		-		-		156
	$	156	$	23	$	233	$	412

During the three months ended June 30, 2014, there were no loans identified as a TDR, and there were no defaults on any loans that were modified as TDRs during the preceding twelve months. During the three months ended June 30, 2013, there were no loans identified as a TDR, and there were no defaults on any loans that were modified as TDRs during the preceding twelve months. During the six months ended June 30, 2014, there was one loan relationship with a pre-modification balance of $1.2 million identified as a TDR through a modification of the original loan terms. The loan was paid off during the second quarter of 2014 and, therefore, is not reflected in the balance of TDRs at June 30, 2014. During the six months ended June 30, 2014, there were no defaults on any loans that were modified as TDRs during the preceding twelve months. During the six months ended June 30, 2013, one loan with a pre-modification balance of $27,000 was identified as a TDR, and there were no defaults on any loans that were modified as TDRs during the preceding twelve months. For purposes of the determination of an allowance for loan losses on these TDRs, as an identified TDR, the Company considers a loss probable on the loan and, as a result is reviewed for specific impairment in accordance with the Company’s allowance for loan loss methodology. If it is determined losses are probable on such TDRs, either because of delinquency or other credit quality indicator, the Company establishes specific reserves for these loans. As of June 30, 2014, there were no commitments to lend additional funds to debtors owing sums to the Company whose terms have been modified in TDRs.