Note 2.

Regulatory Matters and Significant Risks or Uncertainties

FDIC and Department of Banking Memorandum of Understanding

During the fourth quarter of 2011, Royal Bank entered into an informal agreement, known as a memorandum of understanding (“MOU”) with each of the Federal Deposit Insurance Corporation (“FDIC”) and the Pennsylvania Department of Banking (the “Department”). Included in the MOU is the requirement of maintaining a ratio of Tier 1 capital to total assets (“leverage ratio”) equal to or greater than 8% and a total risk-based capital ratio equal to or greater than 12%. At March 31, 2014, based on capital levels calculated under regulatory principles (“RAP”), Royal Bank’s leverage and total risk-based capital ratios were 9.36% and 16.17%, respectively. Please refer to “Note 11 – Regulatory Capital Requirements” to the Consolidated Financial Statements. Under the MOU, Royal Bank must receive prior approval from the FDIC and the Department before declaring and paying a dividend to the Company.

Federal Reserve Agreement

As previously disclosed, in March 2010, the Company agreed to enter into a written agreement (the “Federal Reserve Agreement”) with the Federal Reserve Bank of Philadelphia (the “Federal Reserve Bank”). In July 2013, the Board of Governors of the Federal Reserve System terminated the enforcement action under Federal Reserve Agreement, and it was replaced with an informal non-public agreement, an MOU, with the Federal Reserve Bank, effective July 17, 2013. Included in the MOU are certain continued reporting requirements and a requirement that the Company receive the prior approval of the Federal Reserve Bank and the Director of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System prior to declaring or paying any dividends on the Company’s common stock, making interest payments related to the Company’s outstanding trust preferred securities or subordinate securities, incurring or guaranteeing certain debt with an original maturity date greater than one year, and purchasing or redeeming any shares of stock. The MOU will remain in effect until stayed, modified, terminated or suspended in writing by the Federal Reserve Bank.

Our success as a Company is dependent upon pursuing various alternatives in not only achieving the growth and expansion of our banking franchise but also in managing our day to day operations. The existence of the two MOUs may limit or impact our ability to pursue all previously available alternatives in the management of the Company. Our ability to retain existing retail and commercial customers as well as the ability to attract potentially new customers may be impacted by the existence of the MOUs. Additionally, the Company’s ability to raise capital in the current economic environment could be potentially limited or impacted as a result of the MOUs. Attracting new management talent is critical to the success of our business and could be potentially affected due to the existence of the MOUs.

Net Income

The Company had recorded significant losses over the five years prior to 2013 which were primarily related to charge-offs on the loan and lease portfolio, other-than-temporary impairment (“OTTI”) charges on investment securities, impairment charges on OREO, credit related expenses and the establishment of a deferred tax valuation allowance. In addition to reducing the total shareholders’ equity, the accumulated deficit impacts the Company’s ability to pay cash dividends to its shareholders now and in future years. For the first quarter of 2014, the Company recorded net income of $1.5 million compared to $118,000 for the comparable period in 2013. The quarter over quarter improvement was mainly related to growth in net interest income of $754,000, an increase in the credit for loan and lease of $388,000 and declines in salaries and benefits and credit related expenses of $409,000 and $280,000, respectively. Partially offsetting these positive items was a $676,000 decline in gains on the sale of Company owned real estate, a $71,000 increase in marketing and advertising expenses and a $60,000 rise in occupancy and equipment expenses, which were impacted by the harsh winter conditions in our markets.

Credit Quality

The financial services and real estate industries were hit particularly hard during the “Great Recession” and as a result the Company’s loan and investment portfolios were directly affected. The Company’s commercial real estate loans, including construction and land development loans, saw a decline in the collateral values and a reduction in the borrowers’ ability to meet the payment terms of their loans due to reduced cash flow. Further declines in collateral values and borrowers’ liquidity with sustained unemployment at current levels may lead to additional increases in foreclosures, delinquencies and customer bankruptcies. The Company is less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of more diverse economies.

Royal Bank was successful in reducing net classified assets, which includes special mention, substandard and non-accrual loans and OREO, from $61.4 million at December 31, 2013 to $52.8 million at March 31, 2014. Royal Bank’s delinquent loans held for investment (30 to 90 days) amounted to $2.5 million at March 31, 2014 versus $2.6 million at December 31, 2013. Material advances on any classified or delinquent loan require approval from the Board of Directors and determined to be in Royal Bank’s best interest. The Company recorded $1.2 million in charge-offs for the first quarter of 2014 compared to $2.0 million in charge-offs for the first quarter of 2013.

Liquidity and Funds Management

As of March 31, 2014, Royal Bank had $182.5 million of available borrowing capacity at the FHLB. Royal Bank also has availability to borrow from the Federal Reserve Discount Window, which was approximately $7.8 million at March 31, 2014, and was based on collateral pledged. Borrowings were $102.8 million and $107.9 million at March 31, 2014 and December 31, 2013, respectively. During the first quarter of 2014, Royal Bank secured an additional $10.0 million line of credit, of which $0 is outstanding, with a local financial institution.

At March 31, 2014, the liquidity to deposits ratio was 73.3% compared to Royal Bank’s 12% policy target and the liquidity to total liabilities ratio was 57.6% compared to Royal Bank’s 10% policy target. The Company also has unfunded pension plan obligations, which potentially could impact liquidity, of $14.4 million as of March 31, 2014 compared to $14.5 million at December 31, 2013. The Company plans to fund the pension plan obligations through existing Company owned life insurance policies.

Dividend and Interest Restrictions

Due to the MOU, our ability to obtain lines of credit, to receive attractive collateral treatment from funding sources, and to pursue all attractive funding alternatives in this current low interest rate environment could be impacted and thereby limit liquidity alternatives. On August 13, 2009, the Company’s Board suspended the regular quarterly cash dividends on the $30.4 million in Series A Preferred Stock and the interest payments on the $25.8 million in trust preferred securities. As of March 31, 2014, the Series A Preferred stock dividend in arrears was $8.2 million and has not been recognized in the consolidated financial statements. The Company believes the decision to suspend the preferred cash dividends will better support the liquidity position of Royal Bank. In the event the Company declared the preferred dividend in arrears the Company’s capital ratios would be negatively affected; however, they would remain above the required minimum ratios. During the third quarter of 2013, the Company received approval from the Federal Reserve Bank and paid the interest payment in arrears on the trust preferred securities. The Company received approval and paid the first quarter interest payment in March 2014.

At March 31, 2014, as a result of significant losses within Royal Bank, the Company had negative retained earnings and therefore would not have been able to declare and pay any cash dividends. Royal Bank must receive prior approval from the FDIC and the Department before declaring and paying a dividend to the Company. Under the Federal Reserve Agreement the Company may not declare or pay any dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.

Capital Adequacy

In connection with a prior bank regulatory examination, the FDIC concluded, based upon its interpretation of the Call Report instructions and under RAP, that income from Royal Bank’s tax lien business should be recognized on a cash basis, not an accrual basis. Royal Bank’s current accrual method is in accordance with U.S. GAAP. Royal Bank disagrees with the FDIC’s conclusion and filed the Call Report for March 31, 2014 and the previous 14 quarters in accordance with U.S. GAAP. However, the change in the manner of revenue recognition for the tax lien business for regulatory accounting purposes affects Royal Bank’s and potentially the Company’s capital ratios as disclosed in “Note 11 - Regulatory Capital Requirements” to the Consolidated Financial Statements. The resolution of this matter will be decided by additional joint regulatory agency guidance which includes the Federal Reserve Bank, the FDIC, and the OCC.

Under the MOU, Royal Bank must maintain a minimum Tier 1 leverage ratio and a minimum total risk-based capital ratio of 8% and 12%, respectively. At March 31, 2014, based on capital levels calculated under RAP, Royal Bank’s leverage and total risk-based capital ratios were 9.36% and 16.17%, respectively.

Company Plans and Strategy

During the past few years, the Company recorded significant impairment charges and carrying costs on non-accrual loans and OREO which have weighed heavily on earnings and were the largest contributing factors to the Company’s losses. The Company’s strategic plan included improving the overall level of credit quality, maintaining reduced credit risk within the investment portfolio, reducing the overall level of expenses, returning to profitability, and meeting the capital level requirements for Royal Bank as set forth in the FDIC MOU.

While sustaining capital ratios above the required minimum, the Company has made progress in improving credit quality, reducing the CRE concentration, strengthening the Board and maintaining liquidity. As a result of the decline in level of classified assets, there have been credits rather than provisions to loan and lease losses and a reduction in the overall carrying costs associated with classified assets. The deleveraging of the balance sheet has also reduced earning assets, which has historically resulted in a decline in net interest income and has had a significant impact on overall earnings. To improve net interest margin and net interest income, management is diligently working on changing the mix of earning assets and interest-bearing liabilities. In the event further deleveraging is necessary to maintain the required capital levels, net interest income would be negatively impacted.

During 2013, the strategic plan evolved into transitioning Royal Bank into a community bank built on a solid commercial revenue and retail delivery foundation. During the first quarter of 2013, to support the strategic goals, management had announced a set of sweeping initiatives through the Company's "Profitability Improvement Plan" ("PIP") designed to enhance company-wide efficiency, productivity and modernization. During 2013, the Company realized a 22% reduction in the workforce, which included reorganizing and relocating certain personnel to improve departmental synergies and better align managers and staff so they can work together in cohesive teams to accomplish their objectives. Additionally, pursuant to the real estate rationalization plan under PIP, two branches were consolidated and four Company-owned buildings were sold.

During the first quarter of 2014, the Company reorganized the retail division to better serve existing customers, develop the retail sales teams, and promote attainment of new customer relationships. Also during the first quarter of 2014, the Company continued a successful 50^th anniversary campaign by offering a Kindle to new customers who met certain deposit account opening criteria. In January and April, the Villanova and Phoenixville branches, respectively, were relocated to more convenient, high-traffic locations within the same markets. Plans are being developed to relocate two additional branches.